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EX-32 - EXHIBIT 32 - NATIONAL MENTOR HOLDINGS, INC.c99643exv32.htm
EX-4.2 - EXHIBIT 4.2 - NATIONAL MENTOR HOLDINGS, INC.c99643exv4w2.htm
EX-31.1 - EXHIBIT 31.1 - NATIONAL MENTOR HOLDINGS, INC.c99643exv31w1.htm
EX-31.3 - EXHIBIT 31.3 - NATIONAL MENTOR HOLDINGS, INC.c99643exv31w3.htm
EX-31.2 - EXHIBIT 31.2 - NATIONAL MENTOR HOLDINGS, INC.c99643exv31w2.htm
EX-4.1 - EXHIBIT 4.1 - NATIONAL MENTOR HOLDINGS, INC.c99643exv4w1.htm
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2010
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 number: 333-129179
NATIONAL MENTOR HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
     
Delaware   31-1757086
(State or other jurisdiction of   (I.R.S. Employer Identification No.)
incorporation or organization)    
     
313 Congress Street, 6th Floor    
Boston, Massachusetts 02210   (617) 790-4800
(Address of principal executive offices,   (Registrant’s telephone number,
including zip code)   including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes o No þ
The Company is a voluntary filer of reports required of companies with public securities under Sections 13 or 15(d) of the Securities Exchange Act of 1934 and has filed all reports which would have been required of the Company during the past 12 months had it been subject to such provisions.
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
             
Large accelerated filer o   Accelerated filer o   Non-accelerated filer þ (Do not check if smaller reporting company)   Smaller reporting company 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 þ
As of May 13, 2010, there were 100 shares outstanding of the registrant’s common stock, $.01 par value.
 
 

 

 


 

Index
National Mentor Holdings, Inc.
         
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    38  
 
       
    39  
 
       
    39  
 
       
    39  
 
       
    39  
 
       
    40  
 
       
 Exhibit 4.1
 Exhibit 4.2
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 31.3
 Exhibit 32

 

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PART I. FINANCIAL INFORMATION
Item 1.  
Financial Statements.
National Mentor Holdings, Inc.
Condensed Consolidated Balance Sheets
(In thousands)
(Unaudited)
                 
    March 31,     September 30,  
    2010     2009  
Assets
               
Current assets
               
Cash and cash equivalents
  $ 13,722     $ 23,650  
Restricted cash
    6,995       5,192  
Accounts receivable, net
    121,708       118,969  
Deferred tax assets, net
    11,385       13,897  
Prepaid expenses and other current assets
    15,198       16,868  
 
           
Total current assets
    169,008       178,576  
Property and equipment, net
    142,380       145,876  
Intangible assets, net
    440,708       440,202  
Goodwill
    216,865       206,699  
Other assets
    14,988       16,047  
Investment in related party debt securities
    9,504       8,210  
 
           
Total assets
  $ 993,453     $ 995,610  
 
           
 
               
Liabilities and shareholder’s equity
               
Current liabilities
               
Accounts payable
  $ 20,785     $ 19,819  
Accrued payroll and related costs
    59,835       58,388  
Other accrued liabilities
    43,927       45,000  
Obligations under capital lease, current
    88       118  
Current portion of long-term debt
    3,684       7,415  
 
           
Total current liabilities
    128,319       130,740  
Other long-term liabilities
    14,230       13,462  
Deferred tax liabilities, net
    123,656       125,237  
Obligations under capital lease, less current portion
    1,643       1,680  
Long-term debt, less current portion
    502,627       500,763  
 
           
Total liabilities
    770,475       771,882  
Shareholder’s equity
               
Common stock
           
Additional paid-in-capital
    250,286       250,038  
Other comprehensive loss, net of tax
    (3,415 )     (7,115 )
Accumulated deficit
    (23,893 )     (19,195 )
 
           
Total shareholder’s equity
    222,978       223,728  
 
           
Total liabilities and shareholder’s equity
  $ 993,453     $ 995,610  
 
           
See accompanying notes.

 

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National Mentor Holdings, Inc.
Condensed Consolidated Statements of Operations
(In thousands)
(Unaudited)
                                 
    Three Months Ended     Six Months Ended  
    March 31,     March 31,  
    2010     2009     2010     2009  
Net revenue
  $ 252,502     $ 240,737     $ 504,330     $ 481,970  
Cost of revenue
    193,659       184,386       385,502       367,474  
 
                       
Gross profit
    58,843       56,351       118,828       114,496  
Operating expenses:
                               
General and administrative
    34,197       32,724       68,861       67,326  
Depreciation and amortization
    14,444       13,287       28,866       26,341  
 
                       
Total operating expenses
    48,641       46,011       97,727       93,667  
 
                       
Income from operations
    10,202       10,340       21,101       20,829  
Other income (expense):
                               
Management fee of related party
    (287 )     (259 )     (563 )     (482 )
Other expense, net
    (185 )     (440 )     (128 )     (801 )
Interest income
    18       28       31       144  
Interest income from related party
    469       117       945       117  
Interest expense
    (11,520 )     (11,742 )     (23,401 )     (24,181 )
 
                       
Loss from continuing operations before income taxes
    (1,303 )     (1,956 )     (2,015 )     (4,374 )
Benefit for income taxes
    (736 )     (700 )     (1,369 )     (736 )
 
                       
Loss from continuing operations
    (567 )     (1,256 )     (646 )     (3,638 )
(Loss) income from discontinued operations, net of tax
    (4,089 )     74       (4,052 )     116  
 
                       
Net loss
  $ (4,656 )   $ (1,182 )   $ (4,698 )   $ (3,522 )
 
                       
See accompanying notes.

 

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National Mentor Holdings, Inc.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
                 
    Six Months Ended  
    March 31,  
    2010     2009  
Operating activities
               
Net loss
  $ (4,698 )   $ (3,522 )
Adjustments to reconcile net loss to cash provided by operating activities:
               
Accounts receivable allowances
    5,537       4,709  
Depreciation and amortization of property and equipment
    11,651       10,095  
Amortization of other intangible assets
    17,214       16,361  
Amortization of deferred financing costs
    1,598       1,640  
Accretion of investment in related party debt securities
    (481 )      
Stock-based compensation
    248       835  
Loss on disposal of property and equipment
    389       267  
Gain on disposal of assets
    (43 )     (38 )
Non-cash impairment charge and other charges from discontinued operations
    6,604       300  
Non-cash interest income from related party
    (464 )     (117 )
Changes in operating assets and liabilities:
               
Accounts receivable
    (5,314 )     (12,951 )
Other assets
    1,244       8,730  
Accounts payable
    761       (2,468 )
Accrued payroll and related costs
    411       (1,721 )
Other accrued liabilities
    2,912       2,791  
Deferred taxes
    (6,560 )     (3,071 )
Other long-term liabilities
    768       456  
 
           
Net cash provided by operating activities
    31,777       22,296  
 
               
Investing activities
               
Cash paid for acquisitions, net
    (29,199 )     (13,113 )
Purchases of property and equipment
    (9,061 )     (17,263 )
Purchase of related party debt securities
          (6,555 )
Changes in restricted cash
    (1,800 )      
Cash proceeds from sale of assets
    43       76  
Cash proceeds from sale of discontinued operations
    72       116  
Cash proceeds from sale of property and equipment
    174       520  
 
           
Net cash used in investing activities
    (39,771 )     (36,219 )
 
               
Financing activities
               
Repayments of long-term debt
    (1,867 )     (1,868 )
Repayments of capital lease obligations
    (67 )     (110 )
Dividend to parent
          (7,306 )
Parent capital contribution
          201  
Payments of deferred financing costs
          (33 )
 
           
Net cash used in financing activities
    (1,934 )     (9,116 )
Net decrease in cash and cash equivalents
    (9,928 )     (23,039 )
Cash and cash equivalents at beginning of period
    23,650       38,908  
 
           
Cash and cash equivalents at end of period
  $ 13,722     $ 15,869  
 
           
See accompanying notes.

 

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National Mentor Holdings, Inc.
Notes to Condensed Consolidated Financial Statements
March 31, 2010
(Unaudited)
1. Basis of Presentation
National Mentor Holdings, Inc., through its wholly owned subsidiaries (collectively, the “Company”), is a leading provider of home and community-based human services to adults and children with intellectual and/or developmental disabilities, acquired brain injury and other catastrophic injuries and illnesses; and to youth with emotional, behavioral and medically complex challenges. Since the Company’s founding in 1980, the Company has grown to provide services to approximately 24,000 clients in 36 states. The Company designs customized service plans to meet the unique needs of its clients in home- and community-based settings. Most of the Company’s services involve residential support, typically in small group home or host home settings, designed to improve the clients’ quality of life and to promote client independence and participation in community life. Other services that the Company provides include day programs, vocational services, case management, early intervention, family-based services, post-acute treatment and neurorehabilitation services, among others. The Company’s customized services offer its clients, as well as the payors of these services, an attractive, cost-effective alternative to human services provided in large, institutional settings.
The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the applicable rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The unaudited condensed consolidated financial statements herein should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2009, which is on file with the SEC. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting of normal and recurring accruals) necessary to present fairly the financial statements in accordance with GAAP. All significant intercompany balances and transactions between the Company and its subsidiaries have been eliminated in consolidation. Operating results for the three and six months ended March 31, 2010 may not necessarily be indicative of results to be expected for any other interim period or for the full year.
The preparation of financial statements in conformity with GAAP requires the appropriate application of certain accounting policies, many of which require the Company to make estimates and assumptions about future events and their impact on amounts reported in the financial statements and related notes. Since future events and the impact of those events cannot be determined with certainty, the actual results may differ from the Company’s estimates. These differences could be material to the financial statements.
2. Recently Adopted Accounting Pronouncements
Authoritative guidance has recently been updated governing principles and requirements for the recognition and measurement of identifiable assets acquired, the liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. Some of the changes, such as the accounting for contingent consideration and expensing transaction costs for business combinations may introduce more volatility into earnings. The Company is required to record the present value of contingent consideration for all future years at the time of acquisition. The Company is required to review its estimates on a quarterly basis and subsequent changes to estimates are recorded in the statements of operations in the period of change. The Company adopted this guidance on October 1, 2009 and the statement applies prospectively for business combinations incurred on or after that date.

 

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3. Comprehensive (Loss) Income
The components of comprehensive (loss) income and related tax effects are as follows:
                                 
    Three Months Ended     Six Months Ended  
    March 31,     March 31,  
(in thousands)   2010     2009     2010     2009  
Net loss
  $ (4,656 )   $ (1,182 )   $ (4,698 )   $ (3,522 )
Changes in unrealized gain (losses) on derivatives
    2,984       3,485       5,860       (6,091 )
Changes in unrealized (losses) gain on available-for-sale debt securities
    (265 )           352        
Income tax effect
    (1,100 )     (1,409 )     (2,512 )     2,463  
 
                       
Comprehensive (loss) income
  $ (3,037 )   $ 894     $ (998 )   $ (7,150 )
 
                       
4. Long-Term Debt
The Company’s long-term debt consists of the following:
                 
    March 31,     September 30,  
(in thousands)   2010     2009  
Senior term B loan, principal and interest due in quarterly installments through June 29, 2013
  $ 322,438     $ 324,113  
Senior revolver, due June 29, 2012; quarterly cash interest payments at a variable interest rate
           
Senior subordinated notes, due July 1, 2014; semi-annual cash interest payments due each January 1st and July 1st (interest rate of 11.25%)
    180,000       180,000  
Term loan mortgage, principal and interest due in monthly installments through June 29, 2012; variable interest rate (4.75% at March 31, 2010 and September 30, 2009)
    3,873       4,065  
 
           
 
    506,311       508,178  
Less current portion
    3,684       7,415  
 
           
Long-term debt
  $ 502,627     $ 500,763  
 
           
Senior secured credit facilities
The Company’s senior credit facility consists of a $335.0 million seven-year senior secured term B loan facility (the “term B loan”), a $125.0 million six-year senior secured revolving credit facility (the “senior revolver”) and a $20.0 million six-year senior secured synthetic letter of credit facility (together, the “senior secured credit facilities”).
The senior secured credit facilities and the term loan mortgage have priority in right of payment over all of the Company’s other long-term debt. The senior credit facilities are guaranteed by the Company’s subsidiaries, except for the captive insurance subsidiary, and are secured by substantially all of the assets of the Company.
Total cash paid for interest on the Company’s debt amounted to $15.8 million and $16.1 million for the three months ended March 31, 2010 and 2009, respectively, and $21.8 million and $22.7 million for the six months ended March 31, 2010 and 2009, respectively.
Term B loan
The $335.0 million term B loan amortizes one percent per year, paid quarterly, for the first six years, with the remaining balance due in the seventh year. The senior credit agreement also includes a provision for the prepayment of a portion of the outstanding term loan amounts at any year-end equal to an amount ranging from 0-50% of a calculated amount, depending on the Company’s leverage ratio, if the Company generates certain levels of cash flow. The variable interest rate on the term B loan is equal to LIBOR plus 2.00% or Prime plus 1.00%, at the Company’s option.

 

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To reduce the interest rate exposure on the term B loan, the Company is a party to interest rate swap agreements with respect to $292.2 million of the $322.4 million outstanding as of March 31, 2010.  Effective August 31, 2006, the Company fixed a portion of the term B loan at 5.32% plus 2.00%, of which $85.7 million was outstanding at March 31, 2010.  These swap agreements mature on June 30, 2010.  Effective August 31, 2007, the Company fixed an additional portion of the term B loan debt at 4.89% plus 2.00%, of which $206.5 million was outstanding at March 31, 2010.  This swap agreement matures on September 30, 2010. The Company is considering its options for addressing interest rate exposure after the termination of these swap agreements.
The swap is a derivative and the fair value of the swap agreements, representing the price that would be paid to transfer the liability in an orderly transaction between market participants, was $6.6 million or $3.9 million after taxes at March 31, 2010 and $12.4 million or $7.4 million after taxes at September 30, 2009. The fair value was recorded in current liabilities (under Other accrued liabilities) and was determined based on pricing models and independent formulas using current assumptions.
The Company accounts for these interest rate swaps as cash flow hedges. The effectiveness of the hedge relationships is assessed on a quarterly basis during the term of the hedge by comparing whether the critical terms of the hedge continue to match the terms of the debt. Under this approach, the Company exactly matches the terms of the interest rate swap to the terms of the underlying debt and, therefore, assumes 100% hedge effectiveness. The entire change in fair market value is recorded in shareholder’s equity, net of tax, on the condensed consolidated balance sheets as other comprehensive loss.
Senior revolver and synthetic letter of credit facility
The Company had no borrowings and $115.7 million of availability under the $125.0 million senior revolver as of March 31, 2010. The Company had $29.3 million in standby letters of credit outstanding as of March 31, 2010 related to the Company’s workers’ compensation insurance coverage. Of these letters of credit, $20.0 million were issued under the Company’s synthetic letter of credit facility, and $9.3 million were issued under the Company’s $125.0 million senior revolver. Letters of credit in excess of the $20.0 million synthetic letter of credit facility reduce availability under the Company’s senior revolver. The interest rates for any senior revolver borrowings are equal to either LIBOR plus 2.00% or Prime plus 1.00%, at the Company’s option, and subject to reduction depending on the Company’s leverage ratio.
Senior subordinated notes
The Company issued $180.0 million of 11.25% senior subordinated notes due 2014 (the “senior subordinated notes”) in connection with the merger of NMH MergerSub, Inc., a wholly-owned subsidiary of NMH Investment, LLC (“NMH Investment”), with and into the Company, with the Company as the surviving corporation, on June 29, 2006 (the “Merger”). The senior subordinated notes are guaranteed by the Company’s subsidiaries, except for the captive insurance subsidiary.
Term loan mortgage
In January 2010, the Company entered into an agreement to extend the term of its mortgage facility through June 29, 2012, the maturity date of the senior credit agreement. As a result of this extension, the majority of the term loan mortgage balance has been classified as long-term debt. The term loan mortgage is secured by certain buildings and land of the Company.

 

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Covenants
The senior credit agreement and the indenture governing the senior subordinated notes contain both affirmative and negative financial and non-financial covenants, including limitations on the Company’s ability to incur additional debt, sell material assets, retire, redeem or otherwise reacquire capital stock, acquire the capital stock or assets of another business and pay dividends.
5. Acquisitions
Springbrook
On January 15, 2010, the Company acquired the assets of Springbrook, Inc. and an affiliate (together, “Springbrook”) for $6.3 million, subject to increase based on earnout provisions. Springbrook operates in Arizona and Oregon and provides residential and mental health services to individuals with developmental disabilities and behavioral issues.
Pursuant to the acquisition agreement, the Company agreed to pay up to an additional $3.5 million in cash based upon achieving certain earnings targets (the “earnout”). The fair value of the cash earnout on the date of acquisition was $1.6 million that has been accrued for as contingent consideration. The Company is required to remeasure the fair value of the earnout at each reporting date until the contingency is resolved. Changes to the fair value are recognized in earnings in the period of the change. There was no change in fair value for the quarter ended March 31, 2010.
As a result of the Springbrook acquisition, the Company recorded $1.5 million of goodwill in the Human Services segment, which is expected to be deductible for tax purposes. The acquired intangible assets also included $5.2 million of agency contracts with a weighted average useful life of eleven years, $0.7 million of licenses and permits with a weighted average useful life of ten years and $0.1 million of non-compete/non-solicit with a weighted average useful life of five years.
NeuroRestorative
On February 22, 2010, in a purchase of stock and assets, the Company acquired a provider of neurobehavioral and supported living programs (“NeuroRestorative”) for $17.0 million. NeuroRestorative has operations in Arkansas, Louisiana, Oklahoma and Texas and serves individuals who have sustained a traumatic brain injury.
As a result of the NeuroRestorative acquisition, the Company recorded $5.9 million of goodwill in the Post Acute Specialty Rehabilitation Services segment, none of which is expected to be deductible for tax purposes. The acquired intangible assets included $11.7 million of agency contracts with a weighted average useful life of eleven years, $1.4 million of licenses and permits with a weighed average useful life of ten years, $0.4 million of trade name with a weighed average useful life of eleven years and $0.3 million of non-compete/non-solicit arrangements with a weighed average useful life of five years.

 

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Villages
In addition to Springbrook and NeuroRestorative, the Company acquired two California facilities (together, “Villages”), one on January 29, 2010 and one on February 11, 2010, engaged in neurorehabilitation services for total consideration of $6.0 million. As a result of these acquisitions, the Company recorded $2.7 million of goodwill in the Post Acute Specialty Rehabilitation Services segment, which is expected to be deductible for tax purposes. The acquired intangible assets included $3.0 million of agency contracts with a weighted average useful life of eleven years and $0.3 million of licenses and permits with a weighted average useful life of ten years.
The purchase prices for these acquisitions have been initially allocated as follows:
                         
(in thousands)   Springbrook     NeuroRestorative     Villages  
Accounts receivable, net
  $ 240     $ 2,711     $  
Other assets, current and long-term
    32       781        
Property and equipment
    171       293       20  
Identifiable intangible assets
    5,974       13,763       3,280  
Goodwill
    1,467       5,903       2,742  
Contingent consideration
    (1,617 )            
Accounts payable and accrued expenses
    (7 )     (6,451 )      
 
                 
 
  $ 6,260     $ 17,000     $ 6,042  
 
                 
The operating results of the acquired entities were included in the consolidated statements of operations from the date of acquisition. The Company accounted for the acquisitions under the purchase method of accounting and, as a result, the purchase price was allocated to the assets acquired and liabilities assumed based upon their respective fair values. The excess of the purchase price over the estimated fair market value of net tangible assets was allocated to specifically identified intangible assets, with the residual being allocated to goodwill.
The unaudited pro forma results of operations provided below for the six months ended March 31, 2010 and 2009 is presented as though the acquisitions noted above had occurred at the beginning of the earliest period presented. The pro forma information presented below does not intend to indicate what the Company’s results of operations would have been if the acquisitions had in fact occurred at the beginning of the earliest period presented nor does it intend to be a projection of the impact on future results or trends.
                 
    Six months ended  
    March 31,     March 31,  
    2010     2009  
Net revenue
  $ 519,174     $ 496,265  
Income from operations
    23,694       22,556  
6. Discontinued Operations and Assets Held for Sale
REM Colorado
During the second quarter of fiscal 2010, the Company closed its business operations in the state of Colorado (“REM Colorado”) and recognized a pre-tax impairment charge of $2.5 million. This charge was reported separately as discontinued operations for the three and six months ended March 31, 2010. REM Colorado’s results of operations were immaterial to the consolidated financial statements and have not been reported separately as discontinued operations.
REM Maryland
Also during the second quarter of fiscal 2010, the Company adopted a plan to sell certain business operations in the state of Maryland (“REM Maryland”). For the three and six months ended March 31, 2010, the Company recorded a pre-tax impairment charge of $4.2 million related to the write-down of the REM Maryland assets to fair value and recorded the impairment charge separately as discontinued operations. At March 31, 2010, there was $1.8 million of property and equipment being held for sale.

 

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REM Maryland’s net revenue and loss from operations for the three and six months ended March 31, 2010 and 2009 are summarized as follows:
                                 
    Three Months Ended     Six Months Ended  
    March 31     March 31  
(in thousands)   2010     2009     2010     2009  
Net revenue
  $ 1,337     $ 1,564     $ 2,887     $ 3,258  
Loss from operations
  $ (328 )   $ (162 )   $ (379 )   $ (181 )
REM Maryland’s assets and results of operations are immaterial to the Company and, as a result, are not reported separately as assets held for sale or discontinued operations in the Company’s financial statements.
Both REM Colorado and REM Maryland were reported under the Human Services segment.
7. Related Party Transactions
Investment in Related Party Debt Securities
During fiscal 2009, the Company purchased $11.5 million in aggregate principal amount of senior floating rate toggle notes due 2014 (the “NMH Holdings notes”) issued by the Company’s indirect parent company, NMH Holdings, Inc. (“NMH Holdings”), for $6.6 million. The security was classified as an available-for-sale debt security and was recorded on the Company’s condensed consolidated balance sheets as Investment in related party debt securities. Cash interest on the NMH Holdings notes accrues at a rate per annum, reset quarterly, equal to LIBOR plus 6.375%, and PIK Interest (defined below) accrues at the cash interest rate plus 0.75%. NMH Holdings may elect to pay interest on the NMH Holdings notes (a) entirely in cash, (b) entirely by increasing the principal amount of the NMH Holdings notes or issuing new notes (“PIK Interest”) or (c) 50% in cash and 50% in PIK Interest.
NMH Holdings is a holding company with no direct operations. Its principal assets are the direct and indirect equity interests it holds in its subsidiaries, including the Company, and all of its operations are conducted through the Company and the Company’s subsidiaries. As a result, NMH Holdings will be dependent upon dividends and other payments from the Company to generate the funds necessary to meet its outstanding debt service and other obligations, including its obligations on the notes held by the Company.
NMH Holdings has paid all of the interest payments to date on the NMH Holdings notes entirely in PIK Interest which increased the principal amount by $50.9 million. The Company recorded $0.5 million and $0.9 million of interest income related to the NMH Holdings notes for the three and six months ended March 31, 2010, respectively, which is recorded under Interest income from related party on the condensed consolidated statements of operations. Interest income from related party includes PIK Interest as well as the accretion of the purchase discount on the securities.
As of March 31, 2010, the Company’s investment in related-party debt securities had a carrying value of $8.7 million, and an approximate fair value of $9.5 million which is reflected on the Company’s condensed consolidated balance sheets as Investment in related party debt securities. As a result, the Company has recorded $0.8 million of unrealized holding gain in other comprehensive loss, $0.4 million of which was recorded during the six months ended March 31, 2010. The debt security is scheduled to mature on June 15, 2014, but actual maturities may differ from the contractual or expected maturities since borrowers have the right to prepay obligations with or without prepayment penalties.
The Company evaluates available-for-sale securities for other-than-temporary impairment at least quarterly. If the fair value of a security is less than its cost, an other-than-temporary impairment is required to be recognized if either of the following criteria is met: (1) if the Company intends to sell the security; or (2) if it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis less any current period credit loss. There were no securities impaired on an other than temporary basis for the three and six months ended March 31, 2010.
Lease Agreements
The Company leases several offices, homes and other facilities from its employees, or from relatives of employees, primarily in the states of Minnesota, California and Nevada, which have various expiration dates extending out as far as May 2016. In connection with the acquisition of NeuroRestorative in the second quarter of fiscal 2010, the Company entered into a lease of a treatment facility in Arkansas with a former shareholder and executive who is providing consulting services. The lease is an operating lease with an initial ten-year term, and the total expected minimum lease commitment is $7.0 million. Related party lease expense was $0.9 million and $0.8 million for the three months ended March 31, 2010 and 2009, respectively and $1.8 million and $1.7 million for the six months ended March 31, 2010 and 2009, respectively.

 

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8. Fair Value Measurements
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.
A three-level hierarchy for disclosure has been established to show the extent and level of judgment used to estimate fair value measurements, as follows:
Level 1:  
Quoted market prices in active markets for identical assets or liabilities.
Level 2:  
Significant other observable inputs (quoted prices in active markets for similar assets or liabilities, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability).
Level 3:  
Significant unobservable inputs for the asset or liability. These values are generally determined using pricing models which utilize management estimates of market participant assumptions.
Valuation techniques for assets and liabilities measured using Level 3 inputs may include methodologies such as the market approach, the income approach or the cost approach, and may use unobservable inputs such as projections, estimates and management’s interpretation of current market data. These unobservable inputs are only utilized to the extent that observable inputs are not available or cost-effective to obtain.
A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.
Assets and Liabilities Recorded at Fair Value on a Recurring Basis
                                 
            Quoted     Significant Other     Significant  
            Market Prices     Observable Inputs     Unobservable Inputs  
(in thousands):   Total     (Level 1)     (Level 2)     (Level 3)  
Cash equivalents
  $ 7,400     $ 7,400     $     $  
Interest rate swap agreements
  $ (6,579 )   $     $ (6,579 )   $  
Investment in related party debt securities
  $ 9,504     $     $ 9,504     $  
Contingent consideration
  $ (1,617 )   $     $     $ (1,617 )
Cash equivalents. Cash equivalents consist primarily of money market funds and the carrying value of cash equivalents approximates fair value.
Interest rate swap agreements. The fair value of the swap agreements was recorded in current liabilities (under Other accrued liabilities). The fair value of these agreements was determined based on pricing models and independent formulas using current assumptions that included swap terms, interest rates and forward LIBOR curves.
Investment in related party debt securities. The fair value of the investment in related party debt securities was recorded in long-term assets (under Investment in related party debt securities). The fair value measurements consider observable market data that may include, among other data, credit ratings, credit spreads, future interest rates and risk free rates of return.
Contingent consideration. The fair value of the earnout was accrued for and classified as contingent consideration. The fair value was determined based on unobservable inputs, namely management’s estimate of expected performance based on current information.

 

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At March 31, 2010, the carrying values of cash and cash equivalents, accounts receivable and accounts payable approximated fair value. The carrying value and fair value of the Company’s debt instruments are set forth below:
                                 
    March 31, 2010     September 30, 2009  
    Carrying     Fair     Carrying     Fair  
(in thousands):   Amount     Value     Amount     Value  
Senior subordinated notes
  $ 180,000     $ 180,000     $ 180,000     $ 175,500  
The Company estimated the fair value of the debt instruments using market quotes and calculations based on current market rates available.
9. Income Taxes
The Company files a federal consolidated return and files various state income tax returns and, generally, the Company is no longer subject to income tax examinations by the taxing authorities for years prior to September 30, 2003. The Company’s effective income tax rate for the interim periods was based on management’s estimate of the Company’s annual effective tax rate for the applicable year. For the three months ended March 31, 2010, the Company’s effective income tax rate was 56.5% compared to an effective tax rate of 35.8% for the three months ended March 31, 2009. For the six months ended March 31, 2010, the Company’s effective income tax rate was 67.9% compared to an effective tax rate of 16.8% for the six months ended March 31, 2009. These rates differ from the federal statutory income tax rate primarily due to nondeductible permanent differences such as meals and nondeductible compensation, net operating losses not benefited and changes in the applicability of certain employment tax credits.
The Company’s reserve for uncertain income tax positions at March 31, 2010 is $5.0 million. There has been no change in unrecognized tax benefits in the three or six months ended March 31, 2010 and the Company does not expect any significant changes to unrecognized tax benefits within the next twelve months. The Company’s policy is to recognize interest and penalties related to unrecognized tax benefits as income tax.
10. Segment Information
The Company has two reportable segments, Human Services and Post Acute Specialty Rehabilitation Services (“SRS”).
The Human Services segment provides home and community-based human services to adults and children with intellectual and/or developmental disabilities and to youth with emotional, behavioral and medically complex challenges. Human Services is organized in a reporting structure composed of two operating segments which are aggregated into one reportable segment based on similarity of the economic characteristics and services provided.
The SRS segment provides a mix of health care and community-based human services to individuals with acquired brain injuries and other catastrophic injuries and illnesses. This segment is organized in a reporting structure composed of two operating segments which are aggregated based on similarity of economic characteristics and services provided.
Activities classified as “Corporate” in the table below relate primarily to unallocated home office items.
The Company generally evaluates the performance of its operating segments based on income from operations. The following is a financial summary by reportable operating segment for the periods indicated.
                                 
            Post Acute              
            Specialty              
(in thousands)   Human     Rehabilitation              
For the three months ended March 31,   Services     Services     Corporate     Consolidated  
2010
                               
Net revenue
  $ 222,296     $ 30,206     $     $ 252,502  
Income (loss) from operations
    19,278       3,012       (12,088 )     10,202  
Total assets
    834,975       110,860       47,618       993,453  
Depreciation and amortization
    11,089       2,182       1,173       14,444  
Purchases of property and equipment
    2,435       1,931       765       5,131  
2009
                               
Net revenue
  $ 218,707     $ 22,030     $     $ 240,737  
Income (loss) from operations
    17,798       3,200       (10,658 )     10,340  
Depreciation and amortization
    10,731       1,563       993       13,287  
Purchases of property and equipment
    3,548       1,081       1,588       6,217  

 

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            Post Acute              
            Specialty              
(in thousands)   Human     Rehabilitation              
For the six months ended March 31,   Services     Services     Corporate     Consolidated  
2010
                               
Net revenue
  $ 447,228     $ 57,102     $     $ 504,330  
Income (loss) from operations
    39,667       5,497       (24,063 )     21,101  
Total assets
    834,975       110,860       47,618       993,453  
Depreciation and amortization
    22,398       4,130       2,338       28,866  
Purchases of property and equipment
    5,274       2,305       1,482       9,061  
2009
                               
Net revenue
  $ 438,940     $ 43,030     $     $ 481,970  
Income (loss) from operations
    37,317       5,965       (22,453 )     20,829  
Depreciation and amortization
    21,325       3,061       1,955       26,341  
Purchases of property and equipment
    7,692       6,444       3,127       17,263  
11. Accruals for Self-Insurance and Other Commitments and Contingencies
The Company maintains insurance for employment practices liability, professional and general liability, workers’ compensation liability, automobile liability and health insurance liabilities that include self-insured retentions. The Company intends to maintain such coverage in the future and is of the opinion that its insurance coverage is adequate to cover potential losses on asserted claims. Employment practices liability is fully self-insured and professional and general liability has a self-insured retention of $1.0 million per claim and $2.0 million in the aggregate, with additional insurance coverage above the retention. In connection with the Merger on June 29, 2006, subject to the same retentions, the Company purchased additional insurance for certain claims relating to pre-Merger periods. For workers’ compensation, the Company has a $350 thousand per claim retention with statutory limits. Automobile liability has a $100 thousand per claim retention, with additional insurance coverage above the retention. The Company purchases specific stop loss insurance as protection against extraordinary claims liability for health insurance claims. Stop loss insurance covers claims that exceed $300 thousand on a per member basis.
The Company’s wholly-owned subsidiary captive insurance company provides coverage for the Company’s self-insured portion of professional and general liability claims and its employment practices liability. The accounts of the captive insurance company are fully consolidated with those of the other operations of the Company in the accompanying condensed consolidated financial statements.
The Company is in the human services business and, therefore, has been and reasonably expects it will continue to be subject to claims alleging that the Company, its Mentors, or its employees failed to provide proper care for a client, as well as claims by the Company’s clients, Mentors, employees or community members against the Company for negligence, intentional misconduct or violation of applicable law. Included in the Company’s recent claims are claims alleging personal injury, assault, battery, abuse, wrongful death and other charges. Regulatory agencies may initiate administrative proceedings alleging that the Company’s programs, employees or agents violate statutes and regulations and seek to impose monetary penalties on the Company. The Company could be required to incur significant costs to respond to regulatory investigations or defend against civil lawsuits and, if the Company does not prevail, the Company could be required to pay substantial amounts of money in damages, settlement amounts or penalties arising from these legal proceedings.
The Company accrues for costs related to contingencies when a loss is probable and the amount is reasonably estimable. While the Company believes the provision for contingencies is adequate, the outcome of the legal and other such proceedings is difficult to predict and the Company may settle claims or be subject to judgments for amounts that differ from the Company’s estimates.

 

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Item 2.  
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion of our financial condition and results of operations should be read in conjunction with the historical consolidated financial statements and the related notes included elsewhere in this report. This discussion may contain forward-looking statements about our markets, the demand for our services and our future results. We based these statements on assumptions that we consider reasonable. Actual results may differ materially from those suggested by our forward-looking statements for various reasons, including those discussed in the “Risk factors” and “Forward-looking statements” sections of this report.
Overview
Founded in 1980, we are a leading provider of home and community-based human services to adults and children with intellectual and/or developmental disabilities (“I/DD”), acquired brain injury and other catastrophic injuries and illnesses; and to youth with emotional, behavioral and medically complex challenges, or at risk youth (“ARY”). As of March 31, 2010, we provided our services to approximately 24,000 clients in 36 states through approximately 16,400 full-time equivalent employees. Most of our services involve residential support, typically in small group homes, Intermediate Care Facilities for the Mentally Retarded (“ICFs-MR”) or host home settings, designed to improve our clients’ quality of life and to promote client independence and participation in community life. Our non-residential services consist primarily of day programs and periodic services in various settings. We derive most of our revenue from state and county governmental payors, as well as smaller amounts from non-public payors, mostly for services provided to persons with acquired brain injury and other catastrophic injuries and illnesses.
The largest part of our business is the delivery of services to adults and children with intellectual and/or developmental disabilities. Our I/DD programs include residential support, day habilitation, vocational services, case management, home health care and personal care. We also provide a variety of services to youth with emotional, behavioral and medically complex challenges. Our ARY services include therapeutic foster care, independent living, family reunification, family preservation, alternative schools and adoption services. We also provide a range of post-acute specialty rehabilitation treatment and care services to adults and children with an acquired brain injury and other catastrophic injuries and illnesses. Our specialty rehabilitation services range from post-acute care to assisted independent living and include neurobehavioral rehabilitation, neurorehabilitation, adolescent integration, outpatient or day treatment and pre-vocational services.
We operate our business in two reportable segments, Human Services and Post Acute Specialty Rehabilitation Services (“SRS”). The Human Services segment provides home and community-based human services to adults and children with intellectual and/or developmental disabilities and to youth with emotional, behavioral and medically complex challenges. The SRS segment provides a mix of health care and community-based human services to individuals with acquired brain injuries and other catastrophic injuries and illnesses.
Factors affecting our operating results
Demand for Home and Community-Based Human Services
Our growth in revenue has historically been related to increases in the rates we receive for our services as well as increases in the number of individuals served. This growth has depended largely upon development-driven activities, including the maintenance and expansion of existing contracts and the award of new contracts, and upon acquisitions. We also attribute the continued growth in our client base to certain trends that are increasing demand in our industry, including demographic, medical and political developments.
Demographic trends have a particular impact on our I/DD business. Increases in the life expectancy of individuals with I/DD, we believe, have resulted in steady increases in the demand for I/DD services. In addition, caregivers currently caring for their relatives at home are aging and may soon be unable to continue with these responsibilities. Each of these factors affects the size of the I/DD population in need of services. Similarly, growth for our ARY services has been driven by favorable demographics. Demand for our specialty rehabilitation services has also grown as faster emergency response and improved medical techniques have resulted in more people surviving a traumatic brain injury.
Political and economic trends can also affect our operations. In particular, state budgetary pressures, especially within Medicaid programs, may influence the overall level of payments for our services, the number of clients and the preferred settings for many of the services we provide. Since the beginning of the current economic downturn, our government payors in several states have responded to deteriorating revenue collections by implementing provider rate reductions, including in the states of Arizona, California and Minnesota where we have significant market presence. In addition, the volume of referrals to our programs has also been constrained in many markets as payors have taken steps to reduce spending. We cannot be certain whether there will be further rate reductions in the coming months as state governments address revenue shortfalls.

 

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Historically, pressure from client advocacy groups for the populations we serve has generally helped our business, as these groups generally seek to pressure governments to fund residential services that use our small group home or host home models, rather than large, institutional models. In addition, our ARY services have historically been positively affected by the trend toward privatization of these services. Furthermore, we believe that successful lobbying by these groups has preserved I/DD and ARY services and, therefore, our revenue base, from significant cutbacks as compared with certain other human services. In addition, a number of states have developed community-based waiver programs to support long-term care services for survivors of a traumatic brain injury.
Expansion
We have grown our business through expansion of existing markets and programs as well as through acquisitions.
Organic Growth
We believe that our future growth will depend heavily on our ability to expand existing service contracts and to win new contracts. Our organic expansion activities consist of both new program starts in existing markets and geographical expansion in new markets. Our new program starts typically require us to fund operating losses for a period of approximately 18-24 months. If a new program start does not become profitable during such period, we may terminate it. During the 12 months ended March 31, 2010, losses on new program starts for programs started within the last 18 months that generated operating losses were $3.8 million.
Acquisitions
As of March 31, 2010, we have completed 33 acquisitions since 2004, including several acquisitions of rights to government contracts or fixed assets from small providers, which we integrate with our existing operations. We have pursued larger strategic acquisitions in markets with significant opportunities. Acquisitions could have a material impact on our consolidated financial statements.
On January 15, 2010, we acquired the assets of Springbrook, Inc. and an affiliate (together, “Springbrook”) for $6.3 million, subject to increase based on earnout provisions. Springbrook operates in Arizona and Oregon and provides residential and mental health services to individuals with developmental disabilities and behavioral issues.
On February 22, 2010, in a purchase of stock and assets, we acquired a provider of neurobehavioral and supported living programs (“NeuroRestorative”) for $17.0 million. NeuroRestorative has operations in Arkansas, Louisiana, Oklahoma and Texas and serves individuals who have sustained a traumatic brain injury.
In addition to Springbrook and NeuroRestorative, we acquired two California facilities (together, “Villages”), one on January 29, 2010 and one on February 11, 2010, engaged in neurorehabilitation services for total consideration of $6.0 million.
Divestitures
We regularly review and consider the divestiture of underperforming or non-strategic businesses to improve our operating results and better utilize our capital. We have made divestitures from time to time and expect that we may make additional divestitures in the future. Divestitures could have a material impact on our consolidated financial statements.
Net revenue
Revenue is reported net of allowances for unauthorized sales and estimated sales adjustments by business units. Revenue is also reported net of any state provider taxes or gross receipts taxes levied on services we provide. For the six months ended March 31, 2010, we derived approximately 90% of our net revenue from state and local government payors. The payment terms and rates of these contracts vary widely by jurisdiction and service type, and may be based on per person per diems, rates established by the jurisdiction, cost-based reimbursement, hourly rates and/or units of service. We bill most of our residential services on a per diem basis, and we bill most of our non-residential services on an hourly basis. Some of our revenue is billed pursuant to cost-based reimbursement contracts, under which the billed rate is tied to the underlying costs. Lower than expected cost levels may require us to return previously received payments after cost reports are filed. In addition, our revenue may be affected by adjustments to our billed rates as well as adjustments to previously billed amounts. Revenue in the future may be affected by changes in rate-setting structures, methodologies or interpretations that may be proposed in states where we operate or by the federal government which provides matching funds. We cannot determine the impact of such changes or the effect of any possible governmental actions.

 

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Occasionally, timing of payment streams may be affected by delays by the state related to bill processing systems, staffing or other factors. While these delays have historically impacted our cash position in particular periods, they have not resulted in long-term collections problems.
Expenses
Expenses directly related to providing services are classified as cost of revenue. Direct costs and expenses principally include salaries and benefits for service provider employees, per diem payments to our Mentors, residential occupancy expenses, which are primarily comprised of rent and utilities related to facilities providing direct care, certain client expenses such as food, medicine and transportation costs for clients requiring services. General and administrative expenses primarily include salaries and benefits for administrative employees, or employees that are not directly providing services, administrative occupancy and insurance costs, as well as professional expenses such as consulting, legal and accounting services. Depreciation and amortization includes depreciation for fixed assets utilized in both facilities providing direct care and administrative offices, and amortization related to intangible assets.
Wages and benefits to our employees and per diem payments to our Mentors constitute the most significant operating cost in each of our operations. Most of our employee caregivers are reimbursed on an hourly basis, with hours of work generally tied to client need. Our Mentors are paid on a per diem basis, but only if the Mentor is currently caring for a client. Our labor costs are generally influenced by levels of service and these costs can vary in material respects across regions.
Occupancy costs represent a significant portion of our operating costs. As of March 31, 2010, we owned 406 facilities and one office, and we leased 923 facilities and 277 offices. We incur no facility costs for services provided in the home of a Mentor.
Expenses incurred in connection with liability insurance and third-party claims for professional and general liability totaled 0.4% and 0.5% of our net revenue for the three months ended March 31, 2010 and 2009, respectively and 0.4% of our net revenue for the six months ended March 31, 2010 and 2009. We have incurred professional and general liability claims and insurance expense for professional and general liability of $1.1 million and $1.3 million for the three months ended March 31, 2010 and 2009, respectively and $2.3 million and $2.2 million for the six months ended March 31, 2010 and 2009, respectively. We currently insure through our wholly-owned captive insurance company professional and general liability claims for amounts of up to $1.0 million per claim and up to $2.0 million in the aggregate. Above these limits, we have limited additional third-party coverage. We also insure through our wholly-owned captive insurance company employment practices liability claims of up to $240 thousand per claim and up to $1.0 million in the aggregate.
Our ability to maintain our margin in the future is dependent upon obtaining increases in rates and/or controlling our expenses. In fiscal 2008 and 2009, we invested in our infrastructure initiatives and business process improvements, which had a negative impact on our margin. As we continue to invest in our infrastructure initiatives and business process improvements our margin may continue to be negatively impacted.

 

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Results of Operations
                                 
            Post Acute Specialty              
            Rehabilitation              
Three Months Ended March 31,   Human Services     Services     Corporate     Consolidated  
(in thousands)                                
2010
                               
Net revenue
  $ 222,296     $ 30,206     $     $ 252,502  
Income (loss) from operations
    19,278       3,012       (12,088 )     10,202  
Operating margin
    8.7 %     10.0 %           4.0 %
2009
                               
Net revenue
  $ 218,707     $ 22,030     $     $ 240,737  
Income (loss) from operations
    17,798       3,200       (10,658 )     10,340  
Operating margin
    8.1 %     14.5 %           4.3 %
                                 
            Post Acute Specialty              
            Rehabilitation              
Six Months Ended March 31,   Human Services     Services     Corporate     Consolidated  
(in thousands)  
2010
                               
Net revenue
  $ 447,228     $ 57,102     $     $ 504,330  
Income (loss) from operations
    39,667       5,497       (24,063 )     21,101  
Operating margin
    8.9 %     9.6 %           4.2 %
2009
                               
Net revenue
  $ 438,940     $ 43,030     $     $ 481,970  
Income (loss) from operations
    37,317       5,965       (22,453 )     20,829  
Operating margin
    8.5 %     13.9 %           4.3 %
Three months ended March 31, 2010 compared to three months ended March 31, 2009
Consolidated
Consolidated revenue for the three months ended March 31, 2010 increased by $11.8 million, or 4.9%, compared to revenue for the three months ended March 31, 2009. Revenue increased $13.1 million related to acquisitions that closed during the period from January 1, 2009 to March 31, 2010 and $1.9 million related to organic growth, including growth related to new programs. Revenue growth was partially offset by a reduction in revenue of $3.2 million from businesses we divested during the same period.
Consolidated income from operations decreased from $10.3 million, or 4.3% of revenue, for the three months ended March 31, 2009 to $10.2 million, or 4.0% of revenue, for the three months ended March 31, 2010. Our operating margin decreased due to a $1.2 million increase in depreciation and amortization expense, primarily from acquisitions, a $0.9 million increase in our health insurance costs and a $0.8 million increase related to investment in growth initiatives. This decrease was partially offset by an increase in our cost-containment efforts.
In addition, consolidated net loss increased from $1.2 million for the three months ended March 31, 2009 to $4.7 million for the three months ended March 31, 2010. This increase was primarily due to loss from discontinued operations of $4.1 million, net of tax, related to the impairment charges recorded to close our business operations in the state of Colorado (“REM Colorado”) and to write-down the assets of certain business operations in the state of Maryland (“REM Maryland”) to fair value.
Human Services
Human Services revenue for the three months ended March 31, 2010 increased by $3.6 million, or 1.6% compared to the three months ended March 31, 2009. Revenue increased $7.4 million related to acquisitions that closed during the period from January 1, 2009 to March 31, 2010, but was partially offset by a reduction in revenue of $3.2 million from businesses we divested during the same period. Revenue from existing programs decreased $0.6 million due to a reduction in revenue from programs we closed during the period and due to rate reductions in states in which we operate.
Operating margin increased from 8.1% during the three months ended March 31, 2009 to 8.7% during the three months ended March 31, 2010 primarily due to our ongoing cost-containment efforts. Offsetting the cost-containment efforts was a $0.5 million increase in our health insurance costs as well as a $0.4 million increase in depreciation and amortization expense.
Human Services net loss was negatively impacted by the loss from discontinued operations of $4.1 million, net of tax, related to the impairment charges recorded to close REM Colorado and to write-down the REM Maryland assets to fair value.

 

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Post Acute Specialty Rehabilitation Services
Post Acute Specialty Rehabilitation Services revenue for the three months ended March 31, 2010 increased by $8.2 million, or 37.1%, compared to the three months ended March 31, 2009 due to growth of $5.7 million related to acquisitions that closed during the period from January 1, 2009 to March 31, 2010 and $2.5 million related to organic growth.
Operating margin decreased from 14.5% for the three months ended March 31, 2009 to 10.0% for the three months ended March 31, 2010 primarily due to a $0.8 million increase in growth initiatives, namely $0.3 million related to increased infrastructure and $0.5 million related to new or expanded facilities. Operating margin also decreased due to a $0.6 million increase in depreciation and amortization expense and a $0.4 million increase in health insurance costs.
Corporate
Corporate represents corporate general and administrative expenses. Total corporate expense increased by $1.4 million from the three months ended March 31, 2009 to $12.1 million for the three months ended March 31, 2010. In connection with our consolidation of invoice processing from disparate field locations to a centralized shared services center, corporate expense increased $0.5 million. Expensed transaction costs related to acquisitions also contributed $0.2 million to expense during the three months ended March 31, 2010.
Six months ended March 31, 2010 compared to six months ended March 31, 2009
Consolidated
Consolidated revenue for the six months ended March 31, 2010 increased by $22.4 million, or 4.6%, compared to revenue for the six months ended March 31, 2009. Revenue increased $22.5 million related to acquisitions that closed during fiscal 2009 and 2010 and $6.2 million related to organic growth, including growth related to new programs. Revenue growth was partially offset by a reduction in revenue of $6.3 million from businesses we divested during the same period.
Consolidated income from operations increased from $20.8 million for the six months ended March 31, 2009 to $21.1 million for the six months ended March 31, 2010 while operating margins decreased from 4.3% to 4.2%. Our operating margin decreased due to a $2.5 million increase in depreciation and amortization expense, primarily from acquisitions, a $2.4 million increase in our health insurance costs, a $1.8 million increase in growth initiatives and a $1.1 million increase in our workers’ compensation costs. This decrease was partially offset by an increase in our cost-containment efforts.
In addition, consolidated net loss increased from $3.5 million for the six months ended March 31, 2009 to $4.7 million for the six months ended March 31, 2010. This increase was primarily due to the loss from discontinued operations of $4.1 million, net of tax, related to the impairment charges recorded to close our business operations in REM Colorado and to write-down the REM Maryland assets to fair value.
Human Services
Human Services revenue for the six months ended March 31, 2010 increased by $8.3 million, or 1.9% compared to the six months ended March 31, 2009. Revenue increased $13.7 million related to acquisitions that closed during fiscal 2009 and 2010 and $0.9 million related to organic growth, including growth related to new programs. Human Services revenue growth was offset by a reduction in revenue of $6.3 million from businesses we divested during the same period.
Operating margin increased from 8.5% during the six months ended March 31, 2009 to 8.9% during the six months ended March 31, 2010 primarily due to our ongoing cost-containment efforts. Offsetting our cost-containment efforts were a $1.7 million increase in our health insurance costs, a $1.1 million increase in depreciation and amortization expense and a $0.8 million increase in our workers’ compensation costs.
Human Services net loss was negatively impacted by the loss from discontinued operations of $4.1 million, net of tax, related to the impairment charges recorded to close REM Colorado and to write-down the REM Maryland assets to fair value.
Post Acute Specialty Rehabilitation Services
Post Acute Specialty Rehabilitation Services revenue for the six months ended March 31, 2010 increased by $14.1 million, or 32.7%, compared to the six months ended March 31, 2009. This increase was due to growth of $8.8 million related to acquisitions that closed during fiscal 2009 and 2010 and $5.3 million related to organic growth.
Operating margin decreased from 13.9% for the six months ended March 31, 2009 to 9.6% for the six months ended March 31, 2010 primarily due to a $1.8 million increase in growth initiatives, namely $0.9 million related to increased infrastructure and $0.9 million related to new or expanded facilities. Operating margin also decreased due to a $1.1 million increase in depreciation and amortization expense, a $0.7 million increase in our health insurance costs and a $0.3 million increase in our workers’ compensation costs.

 

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Corporate
Corporate represents corporate general and administrative expenses. Total corporate expense increased by $1.6 million from the six months ended March 31, 2009 to $24.1 million for the six months ended March 31, 2010. In connection with our consolidation of invoice processing from disparate field locations to a centralized shared services center, corporate expense increased $0.8 million. Expensed transaction costs related to acquisitions also contributed $0.7 million to expense during the six months ended March 31, 2010.
Liquidity and Capital Resources
Our principal uses of cash are to meet working capital requirements, fund debt obligations and finance capital expenditures and acquisitions. Cash flows from operations have historically been sufficient to meet these cash requirements. Our principal sources of funds are cash flows from operating activities and available borrowings under our senior credit facilities.
Operating activities
Cash flows provided by operating activities for the six months ended March 31, 2010 were $31.8 million compared to $22.3 million for the six months ended March 31, 2009. Our days sales outstanding decreased one day from 46 days at September 30, 2009 to 45 days at March 31, 2010.
Investing activities
Net cash used in investing activities, primarily consisting of purchases of property and equipment and cash paid for acquisitions, was $39.8 million for the six months ended March 31, 2010 compared to $36.2 million for the six months ended March 31, 2009.
Cash paid for acquisitions for the six months ended March 31, 2010 was $29.2 million, primarily reflecting the acquisitions of NeuroRestorative for $17.0 million and Springbrook for $6.3 million, which is subject to increase based on earnout provisions. The fair value of the cash earnout was $1.6 million for the quarter ended March 31, 2010. In addition to NeuroRestorative and Springbrook, we acquired Villages for total consideration of $6.0 million. Cash paid for acquisitions for the six months ended March 31, 2009 was $13.1 million, primarily reflecting the earnout payment of $12.0 million associated with the CareMeridian acquisition and the acquisition of RIA, Inc. for $0.9 million.
Cash paid for property and equipment for the six months ended March 31, 2010 was $9.1 million, or 1.8% of net revenue, and included $0.9 million related to the purchase of real estate and $0.2 million related to the implementation of a new billing system. Cash paid for property and equipment was $17.3 million, or 3.6% of net revenue, for the six months ended March 31, 2009 and included $4.4 million related to the purchase of real estate and $1.4 million related to the implementation of a new billing system.
Investing activities for the six months ended March 31, 2009 also included the purchase of $11.5 million of senior floating rate toggle notes due 2014 (the “NMH Holdings notes”) from our indirect parent company, NMH Holdings, Inc. (“NMH Holdings”) for $6.6 million.
Financing activities
Net cash used in financing activities was $1.9 million for the six months ended March 31, 2010 compared to $9.1 million for the six months ended March 31, 2009. Our financing activities for the six months ended March 31, 2010 and 2009, included the repayment of long term debt of $1.9 million.
During the six months ended March 31, 2009, we paid a dividend of $7.0 million to our direct parent company, which used the proceeds to make a distribution to NMH Holdings and NMH Holdings used the proceeds of the distribution to repurchase an aggregate principal amount of $13.9 million of the NMH Holdings notes.

 

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We may seek to purchase a portion of our outstanding debt or the debt of NMH Holdings from time to time. The amount of debt that may be purchased, if any, would be decided at the discretion of our Board of Directors and management and will depend on market conditions, prices, contractual restrictions, our liquidity and other factors.
As mentioned above, our principal sources of funds are cash flows from operating activities and available borrowings under the $125.0 million senior revolver. As of March 31, 2010, we did not have any borrowings under our senior revolver. The availability on the senior revolver was reduced by $9.3 million to $115.7 million as letters of credit in excess of $20.0 million under our synthetic letters of credit facility were outstanding. For a description of the senior credit facilities, see note 4 to the condensed consolidated financial statements. We believe that these funds will provide sufficient liquidity and capital resources to meet our near term and future financial obligations, including scheduled principal and interest payments, as well as to provide funds for working capital, capital expenditures and other needs for the foreseeable future.
However, as of March 31, 2010, our indirect parent company, NMH Holdings had $212.0 million aggregate principal amount of the NMH Holdings notes outstanding (including the $12.7 million of which was held by us). NMH Holdings is a holding company with no direct operations. Its principal assets are the direct and indirect equity interests it holds in its subsidiaries, including us, and all of its operations are conducted through us and our subsidiaries. As a result, absent other sources of liquidity, NMH Holdings will be dependent upon dividends and other payments from us to generate the funds necessary to meet its outstanding debt service and other obligations, including its obligations on the notes held by us. NMH Holdings has paid all of the interest payments to date on the notes entirely in PIK Interest (defined below) which increased the principal amount by $50.9 million, including the PIK Interest issued to us. NMH Holdings currently expects to elect to make interest payments entirely by increasing the NMH Holdings notes or issuing new notes (“PIK Interest”) through June 15, 2012. Beginning September 15, 2012, interest payments must be made in cash, including the accrued PIK Interest. We expect the September 2012 payment to be in the range of $95.0 million to $100.0 million depending on interest rates.
Our senior credit agreement and the indenture governing our senior subordinated notes limit our ability to pay dividends to our parent companies. We do not currently expect to have the ability under our debt agreements to make a dividend payment in an amount sufficient to satisfy the payment due in September 2012. In order to fund this payment, NMH Holdings may pursue various financing alternatives, including modifying the terms of our existing indebtedness or the indebtedness of NMH Holdings, raising new capital through debt or equity financing, retiring or purchasing our outstanding debt or the debt of NMH Holdings through exchanges for newly issued debt or equity securities or a combination of these alternatives. Any financings, repurchases or exchanges would be approved by the Board of Directors and will depend on market conditions, prices, contractual restrictions, our liquidity and other factors. Such financings, repurchases or exchanges could have a material impact on our liquidity and could also require amendments to the agreements governing our outstanding debt obligations or those of NMH Holdings. Additional financing may not be available or, if available, may not be made on terms favorable to us.
Covenants
The senior credit agreement and the indenture governing the senior subordinated notes contain both affirmative and negative financial and non-financial covenants, including limitations on our ability to incur additional debt, sell material assets, retire, redeem or otherwise reacquire capital stock, acquire the capital stock or assets of another business and pay dividends. In addition, in the case of the senior credit agreement, we are required to maintain a consolidated leverage ratio of no more than 5.00 to 1.00 as of March 31, 2010 and a consolidated interest coverage ratio of no less than 2.00 to 1.00 for the four consecutive fiscal quarters ended March 31, 2010. The leverage ratio is defined as the ratio of total debt, net of cash and cash equivalents, to consolidated adjusted EBITDA, as defined in the senior credit agreement, for the most recently completed four fiscal quarters. The consolidated interest coverage ratio is defined as the ratio of consolidated adjusted EBITDA to consolidated interest expense, both as defined under the senior credit agreement, for the most recently completed four fiscal quarters. Beginning with the quarter ending December 31, 2010, we will be required to maintain a consolidated leverage ratio of no more than 4.50 to 1.00 and a consolidated interest coverage ratio of no less than 2.25 to 1.00 for the four consecutive fiscal quarters ending December 31, 2010.
As of March 31, 2010, our consolidated leverage ratio was 4.20 to 1.00, as calculated in accordance with the senior credit agreement and our consolidated interest coverage ratio was 2.68 to 1.00, as calculated in accordance with the senior credit agreement. As of March 31, 2010, total debt, net of cash and cash equivalents, was $495.9 million. Under the senior credit agreement, consolidated adjusted EBITDA is defined as net income before interest expense and interest income, income taxes, depreciation and amortization, further adjusted to add back, among other items, permitted start up losses, annualized EBITDA from acquisitions and certain unusual and non- recurring expenses.

 

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Set forth below is a reconciliation of consolidated adjusted EBITDA, as calculated under the credit agreement, to net loss for the most recently completed four fiscal quarters ended March 31, 2010:
         
(in thousands)        
 
       
Net loss
  $ (6,631 )
Loss from discontinued operations, net of tax
    5,347  
Benefit for income taxes
    (2,686 )
Interest income
    (80 )
Interest income from related party
    (2,030 )
Interest expense
    47,474  
Depreciation and amortization
    60,296  
Management fee of related party
    1,227  
Loss on disposal of property and equipment
    1,029  
Loss on disposal of assets
    376  
Stock based compensation
    719  
Predecessor company claims
    1,008  
Acquisition costs
    708  
Annualized EBITDA from acquisitions
    6,982  
Permitted start up losses
    3,764  
Non-recurring fees and expenses
    465  
Other
    154  
 
     
 
       
Consolidated adjusted EBITDA per the senior credit agreement
  $ 118,122  
 
     
Set forth below is a calculation of interest expense, as calculated under the credit agreement, for the most recently completed four fiscal quarters ended March 31, 2010:
         
(in thousands)        
 
       
Interest rate swap agreements
  $ 13,776  
Unused line of credit
    609  
Senior term B loan
    8,546  
Letters of credit
    589  
Senior subordinated notes
    20,250  
Term loan mortgage
    194  
Capital leases
    175  
Interest income
    (80 )
 
     
Interest expense per the senior credit agreement
  $ 44,059  
 
     
The consolidated leverage ratio and the consolidated interest coverage ratios are material components of the senior credit agreement and non-compliance with these ratios could prevent us from borrowing under the senior revolver and would result in a default under the senior credit agreement.
Contractual Commitments Summary
The following table summarizes our contractual obligations and commitments as of March 31, 2010:
                                         
            Less than                     More than  
(in thousands)   Total     1 year     1-3 years     3-5 years     5 years  
Long-term debt obligations(1)
  $ 506,311     $ 3,684     $ 10,245     $ 492,382     $  
Operating lease obligations(2)
    149,897       36,795       52,374       30,751       29,977  
Capital lease obligations
    1,731       88       125       147       1,371  
Standby letters of credit
    29,278       29,278                    
                               
Total obligations and commitments
  $ 687,217     $ 69,845     $ 62,744     $ 523,280     $ 31,348  
                               
 
     
(1)  
Does not include interest on long-term debt or the $210.7 million of senior floating rate toggle notes due 2014, net of discount, issued by NMH Holdings. We hold $12.7 million of the outstanding senior floating rate toggle notes.

 

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(2)  
Includes the fixed rent payable under the leases and does not include additional amounts, such as taxes, that may be payable under the leases.
Off-balance sheet arrangements
We do not have any off-balance sheet transactions or interests.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of financial statements in conformity with GAAP requires the appropriate application of certain accounting policies, many of which require us to make estimates and assumptions about future events and their impact on amounts reported in the financial statements and related notes. Since future events and the impact of those events cannot be determined with certainty, the actual results may differ from our estimates. These differences could be material to the financial statements.
We believe our application of accounting policies, and the estimates inherently required therein, are reasonable. These accounting policies and estimates are constantly reevaluated, and adjustments are made when facts and circumstances dictate a change.
The following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.
Revenue Recognition
Revenue is reported net of any state provider taxes or gross receipts taxes levied on services we provide. Revenue is also reported net of allowances for unauthorized sales and estimated sales adjustments by business units. Sales adjustments are estimated based on an analysis of historical sales adjustments and recent developments in the payment trends in each business unit. Revenue is recognized when evidence of an arrangement exists, the service has been provided, the price is fixed or determinable and collectibility is reasonably assured.
We recognize revenue for services performed pursuant to contracts with various state and local government agencies and private health care agencies as follows: cost-reimbursement contract revenue is recognized at the time the service costs are incurred and units-of-service contract revenue is recognized at the time the service is provided. For our cost-reimbursement contracts, the rate provided by the payor is based on a certain level of service and types of costs incurred in delivering the service. From time to time, we receive payments under cost-reimbursement contracts in excess of the allowable costs required to support those payments. In such instances, we estimate and record a liability for such excess payments. At the end of the contract period, any balance of excess payments is maintained as a liability until it is reimbursed to the payor. Revenue in the future may be affected by changes in rate-setting structures, methodologies or interpretations that may be enacted in states where we operate or by the federal government.
Accounts Receivable
Accounts receivable primarily consist of amounts due from government agencies, not-for-profit providers and commercial insurance companies. An estimated allowance for doubtful accounts is recorded to the extent it is probable that a portion or all of a particular account will not be collected. In evaluating the collectibility of accounts receivable, we consider a number of factors, including payment trends in individual states, age of the accounts and the status of ongoing disputes with third party payors. Complex rules and regulations regarding billing and timely filing requirements in various states are also a factor in our assessment of the collectibility of accounts receivable. Actual collections of accounts receivable in subsequent periods may require changes in the estimated allowance for doubtful accounts. Changes in these estimates are charged or credited to revenue in the statements of operations in the period of the change in estimate.

 

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Accruals for Self-Insurance
We maintain employment practices liability, professional and general liability, workers’ compensation, automobile liability and health insurance with policies that include self-insured retentions. We record expenses related to claims on an incurred basis, which includes estimates of fully developed losses for both reported and unreported claims. The accruals for the health and workers’ compensation, automobile and professional and general liability programs are based on analyses performed internally by management and may take into account reports by independent third parties. Accruals relating to prior periods are periodically reevaluated and increased or decreased based on new information. Changes in estimates are charged or credited to the statements of operations in a period subsequent to the change in estimate.
Goodwill and Indefinite-lived Intangible Assets
We review costs of purchased businesses in excess of net assets acquired (goodwill), and indefinite-life intangible assets for impairment at least annually, unless significant changes in circumstances indicate a potential impairment may have occurred sooner.
We are required to test goodwill on a reporting unit basis, which is the same level as our operating segments. We use a fair value approach to test goodwill for impairment and potential impairment is noted for a reporting unit if its carrying value exceeds the fair value of the reporting unit. For those reporting units that have potential goodwill impairment, we determine the implied fair value of goodwill. If the carrying value of goodwill exceeds its implied fair value, an impairment loss is recorded.
The impairment test for indefinite-life intangible assets requires the determination of the fair value of the intangible asset. If the fair value of the indefinite-life intangible asset is less than its carrying value, an impairment loss is recognized in an amount equal to the difference. Fair values are established using discounted cash flow and comparative market multiple methods. We conduct our annual impairment test on July 1 of each year.
Discounted cash flows are based on management’s estimates of our future performance. As such, actual results may differ from these estimates and lead to a revaluation of our goodwill and indefinite-life intangible assets. If updated calculations indicate that the fair value of goodwill or any indefinite-life intangibles is less than the carrying value of the asset, an impairment charge is recorded in the statements of operations in the period of the change in estimate.
Impairment of Long-Lived Assets
We review long-lived assets for impairment when circumstances indicate the carrying amount of an asset may not be recoverable based on the undiscounted future cash flows of the asset. If the carrying amount of the asset is determined not to be recoverable, a write-down to fair value is recorded based upon various techniques to estimate fair value.
Income Taxes
We account for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. These deferred tax assets and liabilities are separated into current and long-term amounts based on the classification of the related assets and liabilities for financial reporting purposes. Valuation allowances on deferred tax assets are estimated based on our assessment of the realizability of such amounts.
We also recognize the benefits of tax positions when certain criteria are satisfied. We follow the more likely than not recognition threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in an income tax return.
Stock-Based Compensation
NMH Investment, LLC adopted an equity-based compensation plan, and issued units of limited liability company interests pursuant to such plan. The units are limited liability company interests and are available for issuance to our employees and members of the Board of Directors for incentive purposes. For purposes of determining the compensation expense associated with these grants, management values the business enterprise using a variety of widely accepted valuation techniques which considered a number of factors such as our financial performance, the values of comparable companies and the lack of marketability of our equity. We then used the option pricing method to determine the fair value of these units at the time of grant using valuation assumptions consisting of the expected term in which the units will be realized; a risk-free interest rate equal to the U.S. federal treasury bond rate consistent with the term assumption; expected dividend yield, for which there is none; and expected volatility based on the historical data of equity instruments of comparable companies. The Class B and Class E units vest over a five-year service period. The Class C and Class D units vest over a three-year period based on service and on certain performance and/or investment return conditions being met or achieved. The estimated fair value of the units, less an assumed forfeiture rate, is recognized in expense on a straight-line basis over the requisite service/performance periods of the awards.

 

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Derivative Financial Instruments
We report derivative financial instruments on the balance sheet at fair value and establish criteria for designation and effectiveness of hedging relationships. Changes in the fair value of derivatives are recorded each period in current operations or in shareholder’s equity as other comprehensive income (loss) depending upon whether the derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction.
We, from time to time, enter into interest rate swap agreements to hedge against variability in cash flows resulting from fluctuations in the benchmark interest rate, which is LIBOR, on our debt. These agreements involve the exchange of variable interest rates for fixed interest rates over the life of the swap agreement without an exchange of the notional amount upon which the payments are based. On a quarterly basis, the differential to be received or paid as interest rates change is accrued and recognized as an adjustment to interest expense in the accompanying condensed consolidated statement of operations. In addition, on a quarterly basis the mark to market valuation is recorded as an adjustment to other comprehensive income (loss) as a change to shareholder’s equity, net of tax. The related amount receivable from or payable to counterparties is included as an asset or liability in our consolidated balance sheets.
Available-for-Sale Securities
Our investments in related party marketable debt securities have been classified as available-for-sale securities and, accordingly, are valued at fair value at the end of each reporting period. Unrealized gains and losses arising from such valuation are reported, net of applicable income taxes, in other comprehensive income (loss).
Legal Contingencies
From time to time, we are involved in litigation and regulatory proceedings in the operation of our business. We reserve for costs related to contingencies when a loss is probable and the amount is reasonably estimable. While we believe our provision for legal contingencies is adequate, the outcome of our legal proceedings is difficult to predict and we may settle legal claims or be subject to judgments for amounts that differ from our estimates. In addition, legal contingencies could have a material adverse impact on our results of operations in any given future reporting period. See “Part II, Item 1A. Risk Factors” for additional information.
Forward-Looking Statements
Some of the matters discussed in this report may constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially.
The information in this report is not a complete description of our business or the risks associated with our business. There can be no assurance that other factors will not affect the accuracy of these forward-looking statements or that our actual results will not differ materially from the results anticipated in such forward-looking statements. While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include, but are not limited to, those factors or conditions described under “Part II. Item 1A. Risk Factors” in this report as well as the following:
   
changes in Medicaid funding or changes in budgetary priorities by state and local governments;
 
   
our significant amount of debt, our ability to meet our debt service obligations and our ability to incur additional debt;
 
   
current credit and financial market conditions;
 
   
legal proceedings;
 
   
the size of our self-insurance accruals and changes in the insurance market that affect our ability to obtain coverage at reasonable rates;

 

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our ability to control operating costs and collect accounts receivable;
 
   
our ability to maintain, expand and renew existing services contracts and to obtain additional contracts;
 
   
our ability to attract and retain experienced personnel, including members of our senior management team;
 
   
our ability to acquire new licenses or to maintain our status as a licensed service provider in certain jurisdictions;
 
   
government regulations and our ability to comply with such regulations or the interpretations thereof;
 
   
our ability to establish and maintain relationships with government agencies and advocacy groups;
 
   
increased or more effective competition;
 
   
changes in reimbursement rates, policies or payment practices by our payors;
 
   
changes in interest rates;
 
   
successful integration of acquired businesses; and
 
   
possible conflict between the interests of our majority equity holder and those of the holders of our notes.
Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, we do not assume responsibility for the accuracy and completeness of the forward-looking statements. All written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the “Risk Factors” and other cautionary statements included herein. We are under no duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results or to changes in our expectations.
Item 3.  
Quantitative and Qualitative Disclosures about Market Risk.
To reduce the interest rate exposure on the term B loan, the Company is a party to interest rate swap agreements with respect to $292.2 million of the $322.4 million outstanding as of March 31, 2010. Effective August 31, 2006, the Company fixed a portion of the term B loan at 5.32% plus 2.00%, of which $85.7 million was outstanding at March 31, 2010. These swap agreements mature on June 30, 2010. Effective August 31, 2007, the Company fixed an additional portion of the term B loan debt at 4.89% plus 2.00%, of which $206.5 million was outstanding at March 31, 2010. This swap agreement matures on September 30, 2010. The Company is considering its options for addressing interest rate exposure after the termination of these swap agreements.
As a result of the interest rate swap agreements, the variable rate debt outstanding was effectively reduced from $326.3 million outstanding to $34.1 million outstanding as of March 31, 2010. The variable rate debt outstanding relates to the term B loan, which has an interest rate based on LIBOR plus 2.00% or Prime plus 1.00%, the senior revolver, which has an interest rate based on LIBOR plus 2.00% or Prime plus 1.00%, subject to reduction depending on our leverage ratio, and the term loan mortgage, which has an interest rate based on Prime plus 1.50%. A 1% increase in the interest rate on our floating rate debt would increase cash interest expense of the floating rate debt by $0.3 million.

 

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Item 4.  
Controls and Procedures.
None.
Item 4T.  
Controls and Procedures.
(a) Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the SEC, and is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, to allow for timely decisions regarding required disclosure. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. As of March 31, 2010, the end of the period covered by this Quarterly Report on Form 10-Q, our management, with the participation of our principal executive officers and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based on that evaluation, our principal executive officers and principal financial officer concluded that our disclosure controls and procedures were not effective as of March 31, 2010, because they are not yet able to conclude that we have remediated the material weaknesses in internal control over financial reporting identified in Item 9A(T) of our Annual Report on Form 10-K for the fiscal year ended September 30, 2009.
As reported in Item 9A(T) of our Annual Report on Form 10-K for the fiscal year ended September 30, 2009, our management, with the participation of the principal executive officers and principal financial officer, evaluated the effectiveness of our internal control over financial reporting as of September 30, 2009 (management’s most recent assessment of internal control over financial reporting). In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). In connection with this assessment, management identified material weaknesses in our internal control over financial reporting as of September 30, 2009.
A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our financial statements will not be prevented or detected on a timely basis. Our material weaknesses relate to our revenue and accounts receivable balances, as detailed below:
Revenue
As reported in Item 9A(T) of our Annual Report on Form 10-K for the fiscal year ended September 30, 2009, as of fiscal year-end, we had ineffective controls over the accuracy of revenue and accounts receivable balances. As of March 31, 2010, we continued to have the following material weaknesses.
   
We have insufficient segregation of duties within our new billing and accounts receivable system and insufficient controls to ensure appropriate access to our new billing and accounts receivable system and data. This material weakness increases the risk that erroneous or unauthorized revenue transactions could occur and the risk that they would not be detected on a timely basis if they do occur. Management is currently designing processes and controls to limit system access to appropriate personnel and segregate incompatible duties.
   
We have insufficient controls over the accuracy and validity of the billing rates used to calculate revenue recorded in our consolidated financial statements. We previously addressed this material weakness within our legacy accounts receivable system. However, our new billing and accounts receivable system is not yet able to generate timely reports to identify changes to billing rates for periodic review. Therefore, as of March 31, 2010, we have insufficient controls to verify that changes to billing rates entered into the new system were valid and accurate. This control deficiency increases the risk of errors in the invoicing and recording of billings to payors.
   
During the fourth quarter of fiscal 2009, we completed implementation of our new billing and accounts receivable system, operating in a majority of our operations, with the introduction of the system and related controls in multiple locations representing a substantial portion of our revenue. As of March 31, 2010, these controls had not yet been determined to be operating effectively. Because we have not yet conducted our review and testing of revenue controls for the revenue associated with these new locations, we are unable to conclude that these controls are operating effectively, and there can be no assurance that there are not additional material weaknesses relating to revenue.

 

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The following item was first disclosed in our Form 10-Q for the quarterly period ended December 31, 2007. It has not been fully remediated and continues to exist.
   
We have insufficient controls over revenue recognition and revenue reserves for unauthorized sales. We maintain a revenue recognition policy in accordance with U.S. generally accepted accounting principles. However, we lacked controls to ensure definitive, consistent and documented application of the revenue recognition criteria regarding varying local payor contract requirements, specifically with respect to payor service authorization requirements. During the quarter ended September 30, 2009, management undertook a process to remediate the control design by documenting, reviewing and approving local application of revenue recognition requirements and developing a process to assess contract terms in each state to ensure that revenue recognition criteria are being consistently and appropriately interpreted and applied. However, we continue to have insufficient controls to ensure that all unauthorized sales are identified and reserved appropriately in the consolidated financial statements. Generally, if we provide services without a current, valid authorization from the payor agency to provide those services, revenue associated with the unauthorized services may need to be either reserved until such authorization is received, or ultimately written off if authorization is not granted. Management expects our new billing and accounts receivable system, when remediated, to capture more complete and accurate data related to authorizations, which will improve our controls over identifying and reserving for unauthorized sales.
(b) Changes in Internal Control over Financial Reporting
As discussed above, during the quarter ended September 30, 2009, we completed implementation of our new billing and accounts receivable system in a majority of our operations. This billing and accounts receivable system has affected, and will continue to affect, the processes that impact our internal control over financial reporting. As we optimize and remediate the system, we will review the related controls and may take further steps to ensure that they are effective and integrated appropriately.
In addition, during the quarter ended March 31, 2010, we continued to consolidate the processing of vendor invoices from disparate field locations to one centralized location. In connection with this effort, we have redesigned our processes and our controls over the payment of invoices.
Except for the continuing optimization and remediation of our billing and accounts receivable system and consolidation of invoice processing, during the most recent fiscal quarter, there were no significant changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1.  
Legal Proceedings.
We are in the human services business and, therefore, we have been and continue to be subject to claims alleging that we, our employees or our Mentors failed to provide proper care for a client. We are also subject to claims by our clients, our employees, our Mentors or community members against us for negligence, intentional misconduct or violation of applicable laws. Included in our recent claims are claims alleging personal injury, assault, battery, abuse, wrongful death and other charges. Regulatory agencies may initiate administrative proceedings alleging that our programs, employees or agents violate statutes and regulations and seek to impose monetary penalties on us. We could be required to incur significant costs to respond to regulatory investigations or defend against civil lawsuits and, if we do not prevail, we could be required to pay substantial amounts of money in damages, settlement amounts or penalties arising from these legal proceedings.
We reserve for costs related to contingencies when a loss is probable and the amount is reasonably estimable. While we believe our provision for legal contingencies is adequate, the outcome of the legal proceedings is difficult to predict and we may settle legal claims or be subject to judgments for amounts that differ from our estimates.
See “Part I. Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Part II. Item 1A. Risk Factors” for additional information.

 

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Item 1A.  
Risk Factors.
Reductions or changes in Medicaid funding or changes in budgetary priorities by the state and local governments that pay for our services could have a material adverse effect on our revenue and profitability.
We derive the vast majority of our revenue from contracts with state and local governments. These governmental payors fund a significant portion of their payments to us through Medicaid, a joint federal/state health insurance program through which state expenditures are matched by federal funds ranging from, for federal fiscal year 2010, 65% to more than 82% of total costs, a number based largely on a state’s per capita income. Our revenue, therefore, is determined by the level of federal, state and local governmental spending for the services we provide. Budgetary pressures, particularly during recessionary periods, as well as other economic, industry, political and other factors, could cause the federal and state governments to limit spending, which could significantly reduce our revenue, referrals, margins and profitability and adversely affect our growth strategy. Governmental agencies generally condition their contracts with us upon a sufficient budgetary appropriation. If a government agency does not receive an appropriation sufficient to cover its contractual obligations with us, it may terminate a contract or defer or reduce our reimbursement. In addition, there is risk that previously appropriated funds could be reduced through subsequent legislation. Many states in which we operate have been experiencing unprecedented budgetary pressures and have implemented or are considering initiating service reductions, rate freezes and/or rate reductions, including states where we derive significant revenue, such as Minnesota, California and Arizona. Similarly, programmatic changes such as conversions to managed care with related contract demands regarding billing and services, unbundling of services, governmental efforts to increase consumer autonomy and reduce provider oversight, coverage and other changes under state Medicaid plans, may cause unanticipated costs and risks to our service delivery. The loss or reduction of or changes to reimbursement under our contracts could have a material adverse effect on our business, financial condition and operating results.
Reductions in reimbursement rates or failure to obtain increases in reimbursement rates could adversely affect our revenue, cash flows and profitability.
Our revenue and operating profitability depend on our ability to maintain our existing reimbursement levels and to obtain periodic increases in reimbursement rates to meet higher costs and demand for more services. Twelve percent of our revenue is derived from contracts based on a cost reimbursement model where we are reimbursed for our services based on our costs plus an agreed-upon margin. If we are not entitled to, do not receive or cannot negotiate increases in reimbursement rates, or are forced to accept a reduction in our reimbursement rates at approximately the same time as our costs of providing services increase, including labor costs and rent, our margins and profitability could be adversely affected. Changes in how federal and state government agencies operate reimbursement programs can also affect our operating results and financial condition. Some states have, from time to time, revised their rate-setting or methodologies in a manner that has resulted in rate decreases. In some instances, changes in rate-setting methodologies have resulted in third-party payors disallowing, in whole or in part, our requests for reimbursement. Any reduction in or the failure to maintain or increase our reimbursement rates could have a material adverse effect on our business, financial condition and results of operations. Changes in the manner in which state agencies interpret program policies and procedures or review and audit billings and costs could also adversely affect our business, financial condition and operating results and our ability to meet obligations under our indebtedness.
Our level of indebtedness could adversely affect our ability to raise additional capital to fund our operations, and limit our ability to react to changes in the economy or our industry.
We have a significant amount of indebtedness. As of March 31, 2010, we had total indebtedness of $508.0 million, no borrowings under our senior revolver and $115.7 million of availability under our senior revolver. The senior secured credit facilities also include a $20.0 million synthetic letter of credit facility, all of which has been fully utilized. The availability under our senior revolver was reduced from $125.0 million as $9.3 million of letters of credit in excess of $20.0 million under our synthetic letters of credit facility were outstanding under the senior credit agreement.
Our substantial degree of leverage could have important consequences, including the following:
   
it may limit our ability to obtain additional debt or equity financing for working capital, capital expenditures, debt service requirements, acquisitions, and general corporate or other purposes;
   
a substantial portion of our cash flows from operations will be dedicated to the payment of principal and interest on our indebtedness and will not be available for other purposes, including our operations, future business opportunities and capital expenditures;

 

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the debt service requirements of our indebtedness could make it more difficult for us to satisfy our financial obligations;
 
   
a portion of our variable interest rate borrowings under the senior secured credit facilities has not been hedged, exposing us to the risk of increased interest rates;
   
it may limit our ability to adjust to changing market conditions and place us at a competitive disadvantage compared to our competitors that have less debt and a lower degree of leverage; and
   
we may be vulnerable if the current downturn in general economic conditions continues or if there is a downturn in our business, or we may be unable to carry out activities that are important to our growth.
In addition to our indebtedness noted above, our indirect parent company, NMH Holdings had $212.0 million aggregate principal amount of the NMH Holdings notes outstanding as of March 31, 2010 (including the $12.7 million of which was held by us). NMH Holdings is a holding company with no direct operations. Its principal assets are the direct and indirect equity interests it holds in its subsidiaries, including us, and all of its operations are conducted through us and our subsidiaries. As a result, absent other sources of liquidity, NMH Holdings will be dependent upon dividends and other payments from us to generate the funds necessary to meet its outstanding debt service and other obligations, including its obligations on the notes held by us. NMH Holdings has paid all of the interest payments to date on the notes entirely in PIK Interest (defined below) which increased the principal amount by $50.9 million, including the PIK Interest issued to us. NMH Holdings currently expects to elect to make interest payments entirely by increasing the principal amount of the NMH Holdings notes or issuing new NMH Holdings notes (“PIK Interest”) through June 15, 2012. Beginning September 15, 2012, interest payments must be made in cash, including the accrued PIK Interest. We expect the September 2012 payment to be in the range of $95.0 million to $100.0 million depending on interest rates. Our senior credit agreement and the indenture governing our senior subordinated notes limit our ability to pay dividends to our parent companies. We do not currently expect to have the ability under our debt agreements to make a dividend payment in an amount sufficient to satisfy the payment due in September 2012. NMH Holdings may pursue various financing alternatives to fund this payment, any of which could have a material impact on our liquidity and could also require amendments to the agreements governing our outstanding debt obligations or those of NMH Holdings. Additional financing may not be available or, if available, may not be made on terms favorable to us.
Subject to restrictions in the indentures governing our senior subordinated notes and the NMH Holdings notes and the credit agreement governing our senior secured credit facilities, we may be able to incur more debt in the future, which may intensify the risks described in this risk factor. All of the borrowings under the senior secured credit facilities are secured by substantially all of the assets of the Company and its subsidiaries. The NMH Holdings notes are structurally subordinated to the senior subordinated notes and the senior secured credit facilities.
In addition to our high level of indebtedness, we have significant rental obligations under our operating leases for our group homes, other service facilities and administrative offices. For the six months ended March 31, 2010, our aggregate rental payments for these leases, including taxes and operating expenses, was $21.8 million. These obligations could further increase the risks described above.

 

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Current credit and economic conditions could have a material adverse effect on our cash flows, liquidity and financial condition.
Due to the tightening of the credit markets over the last several years, our government payors or other counterparties that owe us money could be delayed in obtaining, or may not be able to obtain, necessary funding and/or financing to meet their cash-flow needs. Moreover, tax revenue continues to be down in many jurisdictions due to the economic recession and high rates of unemployment, and government payors may not be able to pay us for our services until they collect sufficient tax revenue. Delays in payment could have a material adverse effect on our cash flows, liquidity and financial condition. In addition, in the event that our payors or other counterparties delay payments to us, our financial condition could be further impaired if we are unable to borrow additional funds under our senior credit agreement to finance our operations.
Our variable cost structure is directly related to our labor costs, which may be adversely affected by labor shortages, a deterioration in labor relations or increased unionization activities.
Our variable cost structure and operating profitability are directly related to our labor costs. Labor costs may be adversely affected by a variety of factors, including a limited supply of qualified personnel in any geographic area, local competitive forces, the ineffective utilization of our labor force, increases in minimum wages, health care costs and other personnel costs, and adverse changes in client service models. We have incurred higher labor costs in certain markets from time to time because of difficulty in hiring qualified direct service staff. These higher labor costs have resulted from increased wages and overtime and the costs associated with recruitment and retention, training programs and use of temporary staffing personnel. In part to help with the challenge of recruiting and retaining direct care employees, we offer these employees a benefits package that includes paid time off, health insurance, dental insurance, vision coverage, life insurance and a 401(k) plan, and these costs can be significant. In addition, The Patient Protection and Affordable Care Act signed into law on March 23, 2010 will impose new mandates on employers. We are studying the potential impact of these mandates on our costs.
Although our employees are generally not unionized, sixteen of our employees were represented by a labor union until September 30, 2009, when our only unionized program closed. Future unionization activities could result in an increase of our labor and other costs. The Employee Free Choice Act (“EFCA”) of 2009 (H.R. 1409) seeks to amend the National Labor Relations Act to make it easier for workers to be represented by labor unions. If the EFCA or a variation of this legislation becomes law, it could result in increased unionization activities. We may not be able to negotiate labor agreements on satisfactory terms with any future labor unions. If employees covered by a collective bargaining agreement were to engage in a strike, work stoppage or other slowdown, we could experience a disruption of our operations and/or higher ongoing labor costs, which could adversely affect our business, financial condition and results of operations.
Covenants in our debt agreements restrict our business in many ways.
The credit agreement governing the senior secured credit facilities and the indentures governing the senior subordinated notes and the indenture governing the NMH Holdings notes contain various covenants that limit our ability and/or our subsidiaries’ ability to, among other things:
   
incur additional debt or issue certain preferred shares;
 
   
pay dividends on or make distributions in respect of capital stock or make other restricted payments;
 
   
make certain investments;
 
   
sell certain assets;
 
   
create liens on certain assets to secure debt;
 
   
enter into agreements that restrict dividends from subsidiaries;
 
   
consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; and
 
   
enter into certain transactions with our affiliates.

 

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The credit agreement governing the senior secured credit facilities also contains restrictive covenants and requires the Company and its subsidiaries to maintain specified financial ratios and satisfy other financial condition tests. Our ability to meet those financial ratios and tests may be affected by events beyond our control, and we cannot assure you that we will meet those tests. The breach of any of these covenants or financial ratios could result in a default under the senior secured credit facilities and the lenders could elect to declare all amounts borrowed thereunder, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness.
The nature of our operations could subject us to substantial claims, some of which may not be fully insured against or reserved for.
We are in the human services business and, therefore, we have been and continue to be subject to claims alleging that we, our employees or our Mentors failed to provide proper care for a client, as well as claims by our clients, our employees, our Mentors or community members against us for negligence, intentional misconduct or violation of applicable law. Included in our recent claims are claims alleging personal injury, assault, battery, abuse, wrongful death and other charges. Regulatory agencies may initiate administrative proceedings alleging that our programs, employees or agents violate statutes and regulations and seek to impose monetary penalties on us. We could be required to incur significant costs to respond to regulatory investigations or defend against civil lawsuits and, if we do not prevail, we could be required to pay substantial amounts of money in damages, settlement amounts or penalties arising from these legal proceedings. We currently insure through our captive subsidiary amounts of up to $1.0 million per claim and up to $2.0 million in the aggregate. Above these limits, we have limited additional third-party coverage. Awards for punitive damages may be excluded from our insurance policies either contractually or by operation of state law.
We also are subject to potential lawsuits under the False Claims Act or other federal and state whistleblower statutes designed to combat fraud and abuse in the health care industry. These lawsuits can involve significant monetary awards and bounties to private plaintiffs who successfully bring these suits. Finally, we are also subject to employee-related claims under state and federal law, including claims for discrimination, wrongful discharge or retaliation; claims for wage and hour violations under the Fair Labor Standards Act or state wage and hour laws; and novel intentional tort claims.
A litigation award excluded by, or in excess of, our third-party insurance limits and self-insurance reserves could have a material adverse impact on our operations and cash flow and could adversely impact our ability to continue to purchase appropriate liability insurance. Even if we are successful in our defense, civil lawsuits or regulatory proceedings could also irreparably damage our reputation.
Because a substantial portion of NMH Holdings’ and our indebtedness bears interest at rates that fluctuate with changes in certain prevailing short-term interest rates, we are vulnerable to interest rate increases.
A substantial portion of our indebtedness, including borrowings under the senior revolver, the portion of our borrowings under the senior secured term loan facility for which the Company has not hedged its interest rate exposure under interest rate swap agreements, and the indebtedness of NMH Holdings under the NMH Holdings notes, bears interest at rates that fluctuate with changes in certain short-term prevailing interest rates. If interest rates increase, our and NMH Holdings’ debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same.
As of March 31, 2010, we had $34.1 million of floating rate debt outstanding after giving effect to interest rate swaps. As of March 31, 2010, NMH Holdings had $210.7 million of floating rate debt outstanding, net of discount, excluding the debt of its subsidiaries. A 1% increase in the interest rate on our floating rate debt would have increased cash interest expense of the floating rate debt by $0.3 million, and a 1% increase in the interest rate on the NMH Holdings notes would increase NMH Holdings’ interest expense on those notes by $2.1 million. If interest rates increase dramatically, NMH Holdings and the Company and its subsidiaries could be unable to service their debt.
The counterparties to our derivative financial instruments are substantial multi-national financial institutions. Although we consider the risk of counterparty nonperformance to be low, we cannot assure you that our counterparties will not default. If a counterparty defaulted, the effect on our results of operations could be material.

 

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The nature of services that we provide could subject us to significant workers’ compensation related liability, some of which may not be fully reserved for.
We use a combination of insurance and self-insurance plans to provide for potential liability for workers’ compensation claims. Because of our high ratio of employees per client, and because of the inherent physical risk associated with the interaction of employees with our clients, many of whom have intensive care needs, the potential for incidents giving rise to workers’ compensation liability is relatively high.
We estimate liabilities associated with workers’ compensation risk and establish reserves each quarter based on internal valuations, third-party actuarial advice, historical loss development factors and other assumptions believed to be reasonable under the circumstances. As reported in Part I, Item 2 of this Quarterly Report on Form 10-Q for the six months ended March 31, 2010, we recorded an increased charge for workers’ compensation expense compared to the six months ended March 31, 2009. Our results of operations have been adversely impacted and may be adversely impacted in the future if actual occurrences and claims exceed our assumptions and historical trends.
If any of the state and local government agencies with which we have contracts determines that we have not complied with our contracts or have violated any applicable laws or regulations, our revenue may decrease, we may be subject to fines or penalties and we may be required to restructure our billing and collection methods.
We derive the vast majority of our revenue from state and local government agencies, and a substantial portion of this revenue is state-funded with federal Medicaid matching dollars. As a result of our participation in these government-funded programs, we are routinely subject to governmental reviews, audits and investigations to verify our compliance with applicable laws and regulations. As a result of these reviews, audits and investigations, these governmental payors may be entitled to, in their discretion:
   
require us to refund amounts we have previously been paid;
   
terminate or modify our existing contracts;
   
suspend or prevent us from receiving new contracts or extending existing contracts;
   
impose referral holds on us;
   
impose fines, penalties or other sanctions on us; and
   
reduce the amount we are paid under our existing contracts.
As a result of past reviews and audits of our operations, we have been subject to some of these actions from time to time. While we do not currently believe that our existing audit proceedings will have a material adverse effect on our financial condition or significantly harm our reputation, we cannot assure you that similar actions in the future will not do so. In addition, such proceedings could have a material adverse impact on our results of operations in a future reporting period.
In some states, we operate on a cost reimbursement model in which revenue is recognized at the time costs are incurred. In these states, payors audit our historical costs on a regular basis, and if it is determined that our historical costs are insufficient to justify our rates, our rates may be reduced, or we may be required to return fees paid to us in prior periods. In some cases we have experienced negative audit adjustments which are based on subjective judgments of reasonableness, necessity or allocation of costs in our services provided to clients. These adjustments are generally required to be negotiated as part of the overall audit resolution and may result in paybacks to payors and adjustments of our rates. We cannot assure you that our rates will be maintained, or that we will be able to keep all payments made to us, until an audit of the relevant period is complete. Moreover, if we are required to restructure our billing and collection methods, these changes could be disruptive to our operations and costly to implement.
If we fail to establish and maintain relationships with state and local government agencies, we may not be able to successfully procure or retain government-sponsored contracts, which could negatively impact our revenue.
To facilitate our ability to procure or retain government-sponsored contracts, we rely in part on establishing and maintaining relationships with officials of various government agencies. These relationships enable us to maintain and renew existing contracts and obtain new contracts and referrals. The effectiveness of our relationships may be reduced or eliminated with changes in the personnel holding various government offices or staff positions. We also may lose key personnel who have these relationships and such personnel are generally not subject to non-compete or non-solicitation covenants. Any failure to establish, maintain or manage relationships with government and agency personnel may hinder our ability to procure or retain government-sponsored contracts, and could negatively impact our revenue.

 

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Negative publicity or changes in public perception of our services may adversely affect our ability to obtain new contracts and renew existing ones.
Our success in obtaining new contracts and renewals of our existing contracts depend upon maintaining our reputation as a quality service provider among governmental authorities, advocacy groups, families of our clients and the public. Negative publicity, changes in public perception, legal proceedings and government investigations with respect to our operations could damage our reputation and hinder our ability to retain contracts and obtain new contracts, and could reduce referrals, increase government scrutiny and compliance costs, or generally discourage clients from using our services. Any of these events could have a material adverse effect on our business, financial condition and operating results.
We face substantial competition in attracting and retaining experienced personnel, and we may be unable to maintain or grow our business if we cannot attract and retain qualified employees.
Our success depends to a significant degree on our ability to attract and retain qualified and experienced human service professionals who possess the skills and experience necessary to deliver quality services to our clients and manage our operations. We face competition for certain categories of our employees, particularly service provider employees, based on the wages, benefits and other working conditions we offer. Contractual requirements and client needs determine the number, education and experience levels of human service professionals we hire. Our ability to attract and retain employees with the requisite credentials, experience and skills depends on several factors, including, but not limited to, our ability to offer competitive wages, benefits and professional growth opportunities. The inability to attract and retain experienced personnel could have a material adverse effect on our business.
We may not realize the anticipated benefits of any future acquisitions and we may experience difficulties in integrating these acquisitions.
As part of our growth strategy, we intend to make selective acquisitions. Growing our business through acquisitions involves risks because with any acquisition there is the possibility that:
   
we may be unable to maintain and renew the contracts of the acquired business;
 
   
unforeseen difficulties may arise in integrating the acquired operations, including information systems and accounting controls;
 
   
we may not achieve operating efficiencies, synergies, economies of scale and cost reductions as expected;
 
   
the business we acquire may not continue to generate income at the same historical levels on which we based our acquisition decision;
 
   
management may be distracted from overseeing existing operations by the need to integrate the acquired business;
 
   
we may acquire or assume unexpected liabilities or there may be other unanticipated costs;
 
   
we may encounter unanticipated regulatory risk;
 
   
we may experience problems entering new markets or service lines in which we have limited or no experience;
 
   
we may fail to retain and assimilate key employees of the acquired business;
 
   
we may finance the acquisition by incurring additional debt and further increase our leverage ratios; and
 
   
the culture of the acquired business may not match well with our culture.
As a result of these risks, there can be no assurance that any future acquisition will be successful or that it will not have a material adverse effect on our financial condition and results of operations.

 

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A loss of our status as a licensed service provider in any jurisdiction could result in the termination of existing services and our inability to market our services in that jurisdiction.
We operate in numerous jurisdictions and are required to maintain licenses and certifications in order to conduct our operations in each of them. Each state and local government has its own regulations, which can be complicated, and each of our service lines can be regulated differently within a particular jurisdiction. As a result, maintaining the necessary licenses and certifications to conduct our operations can be cumbersome. Our licenses and certifications could be suspended, revoked or terminated for a number of reasons, including:
   
the failure by our employees or Mentors to properly care for clients;
   
the failure to submit proper documentation to the applicable government agency, including documentation supporting reimbursements for costs;
   
the failure by our programs to abide by the applicable regulations relating to the provision of human services; or
   
the failure of our facilities to comply with the applicable building, health and safety codes and ordinances.
From time to time, some of our licenses or certifications are temporarily placed on probationary status or suspended. If we lost our status as a licensed provider of human services in any jurisdiction or any other required certification, we would be unable to market our services in that jurisdiction, and the contracts under which we provide services in that jurisdiction would be subject to termination. Moreover, such an event could constitute a violation of provisions of contracts in other jurisdictions, resulting in other contract, license or certification terminations. Any of these events could have a material adverse effect on our operations.
We are subject to extensive governmental regulations, which require significant compliance expenditures, and a failure to comply with these regulations could adversely affect our business.
We must comply with comprehensive government regulation of our business, including statutes, regulations and policies governing the licensing of our facilities, the maintenance and management of our work place for our employees, the quality of our service, the revenue we receive for our services, and reimbursement for the cost of our services. Compliance with these laws, regulations and policies is expensive, and if we fail to comply with these laws, regulations and policies, we could lose contracts and the related revenue, thereby harming our financial results. State and federal regulatory agencies have broad discretionary powers over the administration and enforcement of laws and regulations that govern our operations. A material violation of a law or regulation could subject us to fines and penalties and in some circumstances could disqualify some or all of the facilities and programs under our control from future participation in Medicaid or other government programs. The Health Insurance Portability and Accountability Act of 1996 (as amended, “HIPAA”), which requires the establishment of privacy standards for health care information storage, retrieval and dissemination as well as electronic transmission and security standards, could result in potential penalties in certain of our businesses if we fail to comply with these privacy and security standards.
Expenses incurred under governmental agency contracts for any of our services, as well as management contracts with providers of record for such agencies, are subject to review by agencies administering the contracts and services. Representatives of those agencies visit our group homes to verify compliance with state and local regulations governing our home operations. A negative outcome from any of these examinations could increase government scrutiny, increase compliance costs or hinder our ability to obtain or retain contracts. Any of these events could have a material adverse effect on our business, financial condition and operating results.
We have identified material weaknesses in our internal control over financial reporting.
In connection with our internal controls assessment required by the Sarbanes-Oxley Act of 2002 and as reported in Item 9A(T) of our Annual Report on Form 10-K for the fiscal year ended September 30, 2009, we identified material weaknesses in our internal control over financial reporting. Management concluded that as of September 30, 2009, our internal control over financial reporting was not effective and, as a result, our disclosure controls and procedures were not effective. Descriptions of the material weaknesses are included in Item 4(T) of this Quarterly Report on Form 10-Q. We also reported material weaknesses in our prior year assessment, for the fiscal year ended September 30, 2008, including a material weakness in controls to verify the existence of our fixed asset balances. In connection with this material weakness, we identified errors during the quarter ended June 30, 2009 which resulted in an adjustment to reduce property and equipment by $1.8 million. While we have taken action and continue to take actions to remediate our identified material weaknesses, our new policies and procedures, when

 

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implemented, may not be effective in remedying all of the deficiencies in our internal control over financial reporting. The decentralized nature of our operations and the manual nature of many of our controls make compliance with the requirements of Section 404 and remediation of our material weaknesses especially challenging. The continuing optimization and remediation of our new billing and accounts receivable system and the consolidation of invoice processing at one centralized location have affected and will continue to affect a number of processes that impact our internal control over financial reporting, and we may identify additional material weaknesses or significant deficiencies in connection with these changes. A failure to remedy our material weaknesses in internal control over financial reporting could result in material misstatements in our financial statements and could impede an upgrade to our credit rating, even if our creditworthiness otherwise improves. Moreover, any future disclosures of additional material weaknesses, or errors as a result of those weaknesses, may result in a negative reaction in the financial markets if there is a loss of confidence in the reliability of our financial reporting.
We have extensive work remaining to remedy the material weaknesses in our internal control over financial reporting, and until our remediation efforts are completed, management will continue to devote significant time and attention to these efforts. We will continue to incur costs associated with implementing additional processes, including fees for additional auditor services and consulting services, and may be required to incur additional costs in improving our internal controls and hiring additional personnel, which could negatively affect our financial condition and operating results.
The high level of competition in our industry could adversely affect our contract and revenue base.
We compete with a wide variety of competitors, ranging from small, local agencies to a few large, national organizations. Competitive factors may favor other providers and reduce our ability to obtain contracts, which would hinder our growth. Not-for-profit organizations are active in all states and range from small agencies serving a limited area with specific programs to multi-state organizations. Smaller local organizations may have a better understanding of the local conditions and may be better able to gain political and public acceptance. Not-for-profit providers may be affiliated with advocacy groups, health organizations or religious organizations that have substantial influence with legislators and government agencies. Increased competition may result in pricing pressures, loss of or failure to gain market share or loss of clients or payors, any of which could harm our business.
We rely on third parties to refer clients to our facilities and programs.
We receive substantially all of our clients from third-party referrals and are governed by the federal anti-kickback/non-self referral statute. Our reputation and prior experience with agency staff, care workers and others in positions to make referrals to us are important for building and maintaining our operations. Any event that harms our reputation or creates negative experiences with such third parties could impact our ability to receive referrals and grow our client base.
Home and community-based human services may become less popular among our targeted client populations and/or state and local governments, which would adversely affect our results of operations.
Our growth depends on the continuation of trends in our industry toward providing services to individuals in smaller, community-based settings and increasing the percentage of individuals served by non-governmental providers. The continuation of these trends and our future success are subject to a variety of political, economic, social and legal pressures, all of which are beyond our control. A reversal in the downsizing and privatization trends could reduce the demand for our services, which could adversely affect our revenue and profitability.
Regulations that require ARY services to be provided through not-for-profit organizations could harm our revenue or gross margin.
Two percent of our net revenue for the six months ended March 31, 2010 was derived from contracts with affiliates of Alliance Health and Human Services Inc., or “Alliance,”, an independent not-for-profit organization that has licenses and contracts from several state and local agencies to provide ARY services.
Historically, some state governments interpreted federal law to preclude them from receiving federal reimbursement under Title IV-E of the Social Security Act for ARY services provided under a contract with a proprietary organization. However, in 2005 the Fair Access Foster Care Act of 2005 was signed into law, thereby allowing states to seek reimbursement from the federal government for ARY services provided by proprietary organizations. In some jurisdictions that interpreted the prior federal law to preclude them from seeking reimbursement for ARY services provided under a contract with a proprietary provider, or in others that prefer to contract with not-for-profit providers, we provide ARY services as a subcontractor of Alliance. We do not control Alliance, and none of our employees or agents has a role in the management of Alliance. Although

 

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Edward M. Murphy, our Chief Executive Officer, was an officer and director of Alliance immediately prior to becoming our President in September 2004, Mr. Murphy has no role in the management of Alliance. Our ARY business could be harmed if Alliance chooses to discontinue all or a portion of its service agreements with us. Our ARY business could also be harmed if the state or local governments that prefer that ARY services be provided by not-for-profit organizations determine that they do not want the service performed indirectly by for-profit companies like us on behalf of not-for-profit organizations. We cannot assure you that our contracts with Alliance will continue, and if these contracts are terminated without our consent, it could have an adverse effect on our business, financial condition and operating results. Alliance and its subsidiaries are organized as non-profit corporations and are recognized as tax-exempt under section 501(c)(3) of the Internal Revenue Code. As such, Alliance is subject to the public charity regulations of the states in which it operates and to the federal regulations governing tax-exempt entities. If Alliance fails to comply with the laws and regulations of the states in which it operates or with the federal regulations, it could be subject to penalties and sanctions, including the loss of tax-exempt status, which could preclude it from continuing to contract with certain state and local governments. Our business could be harmed if Alliance lost its contracts and was therefore unable to continue to contract with us.
Government reimbursement procedures are time-consuming and complex, and failure to comply with these procedures could adversely affect our liquidity, cash flows and operating results.
The government reimbursement process is time-consuming and complex, and there can be delays before we receive payment. Government reimbursement, group home credentialing and Medicaid recipient eligibility and service authorization procedures are often complicated and burdensome, and delays can result from, among other things, securing documentation and coordinating necessary eligibility paperwork between agencies. These reimbursement and procedural issues occasionally cause us to have to resubmit claims several times before payment is remitted. If there is a billing error, the process to resolve the error may be time-consuming and costly. To the extent that complexity associated with billing for our services causes delays in our cash collections, we assume the financial risk of increased carrying costs associated with the aging of our accounts receivable as well as increased potential for write-offs. We can provide no assurance that we will be able to collect payment for claims at our current levels in future periods. The risks associated with third-party payors and the inability to monitor and manage accounts receivable successfully could have a material adverse effect on our liquidity, cash flows and operating results.
We conduct a significant percentage of our operations in Minnesota and, as a result, we are particularly susceptible to any reduction in budget appropriations for our services or any other adverse developments in that state.
For the six months ended March 31, 2010, 16% of our revenue was generated from contracts with government agencies in the state of Minnesota. Accordingly, any reduction in Minnesota’s budgetary appropriations for our services, whether as a result of fiscal constraints due to recession, changes in policy or otherwise, could result in a reduction in our fees and possibly the loss of contracts. Last year, Minnesota enacted a rate cut of 2.58%, which took retroactive effect July 1, 2009, and the governor has proposed an additional 2.50% rate cut to take effect July 1, 2010. While the legislature has not adopted the proposal for an additional rate cut at this time, we cannot assure you that we will not receive further rate reductions this year or in the future. The concentration of our operations in Minnesota also makes us particularly susceptible to many of the other risks described above occurring in this state, including:
   
the failure to maintain and renew our licenses;
   
the failure to maintain important relationships with officials of government agencies; and
   
any negative publicity regarding our operations.
Any of these adverse developments occurring in Minnesota could result in a reduction in revenue or a loss of contracts, which could have a material adverse effect on our results of operations, financial position and cash flows.
We depend upon the continued services of certain members of our senior management team, without whom our business operations could be significantly disrupted.
Our success depends, in part, on the continued contributions of our senior officers and other key employees. Our management team has significant industry experience and would be difficult to replace. If we lose or suffer an extended interruption in the service of one or more of our senior officers, our financial condition and operating results could be adversely affected. The market for qualified individuals is highly competitive and we may not be able to attract and retain qualified personnel to replace or succeed members of our senior management or other key employees, should the need arise.

 

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Our success depends on our ability to manage growing and changing operations.
Since 1998, our business has grown significantly in size and complexity. This growth has placed, and is expected to continue to place, significant demands on our management, systems, internal controls and financial and physical resources. Our operations are highly decentralized, with many billing, accounting and collection functions being performed at the local level. This requires us to expend significant resources implementing and monitoring compliance at the local level. In addition, we expect that we will need to further develop our financial and managerial controls and reporting systems to accommodate future growth. This will require us to incur expenses for hiring additional qualified personnel, retaining professionals to assist in developing the appropriate control systems and expanding our information technology infrastructure. The nature of our business is such that qualified management personnel can be difficult to find. Our inability to manage growth effectively could have a material adverse effect on our results of operations, financial position and cash flows.
We may be more susceptible to the effects of a public health catastrophe than other businesses due to the vulnerable nature of our client population.
Our primary clients are individuals with developmental disabilities, brain injuries, or emotionally, behaviorally or medically complex challenges, many of whom may be more vulnerable than the general public in a public health catastrophe. For example, in a flu pandemic, we could suffer significant losses to our client population and, at a high cost, be required to hire replacement staff and Mentors for workers who drop out of the workforce in very tight labor markets. Accordingly, certain public health catastrophes such as a flu pandemic could have a material adverse effect on our financial condition and results of operations.
We are controlled by our principal equityholder, which has the power to take unilateral action.
Vestar controls our business affairs and policies. Circumstances may occur in which the interests of Vestar could be in conflict with the interests of our debt holders. In addition, Vestar may have an interest in pursuing acquisitions, divestitures or other transactions that, in their judgment, could enhance their equity investment, even though such transactions might involve risks to our debt holders. For example, we may pursue various financing alternatives in order to fund required cash payments on the NMH Holdings notes, accrued interest for which will be due and payable in cash beginning September 15, 2012. Vestar is in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us. Vestar may also pursue acquisition opportunities that may be complementary to our business and, as a result, those acquisition opportunities may not be available to us. So long as investment funds associated with or designated by Vestar continue to own a significant amount of our equity interests, even if such amount is less than 50%, Vestar will continue to be able to significantly influence or effectively control our decisions.
Item 2.  
Unregistered Sales of Equity Securities and Use of Proceeds.
Unregistered Sales of Equity Securities
No equity securities of the Company were sold during the three months ended March 31, 2010; however, the Company’s indirect parent, NMH Investment, LLC (“NMH Investment”), did sell equity securities during this period.
The following table sets forth the number of units of common equity of NMH Investment issued during the quarter ended March 31, 2010 pursuant to the NMH Investment, LLC Amended and Restated 2006 Unit Plan, as amended. The units were issued under Rule 701 promulgated under the Securities Act of 1933.
                         
Dates   Title of Securities   Amount     Purchasers   Consideration  
January 12, 2010 to January 20, 2010
  Class B Common Units     12,031.25     Certain employees   $ 601.56  
 
  Class C Common Units     12,625.00         $ 378.75  
 
  Class D Common Units     13,375.00         $ 133.75  
Repurchases of Equity Securities
No equity securities of the Company were repurchased during the three months ended March 31, 2010, and no repurchases were made by NMH Investment.

 

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The Company did not repurchase any of its common stock as part of an equity repurchase program during the second quarter of fiscal 2010.
Item 3.  
Defaults Upon Senior Securities.
None.
Item 4.  
(Removed and Reserved).
Item 5.  
Other Information.
None.
Item 6.  
Exhibits.
The Exhibit Index is incorporated herein by reference.

 

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SIGNATURES
Pursuant to the requirements 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.
         
  NATIONAL MENTOR HOLDINGS, INC.
 
 
May 13, 2010  By:   /s/ Denis M. Holler    
    Denis M. Holler   
  Its:  Executive Vice President, Chief Financial Officer,
Treasurer and duly authorized officer 
 

 

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EXHIBIT INDEX
             
Exhibit No.   Description    
  3.1    
Amended and Restated Certificate of Incorporation of National Mentor Holdings, Inc.
  Incorporated by reference to Exhibit 3.1 of National Mentor Holdings, Inc. Form 10-Q for the quarterly period ended March 31, 2007 (the “March 2007 10-Q”)
       
 
   
  3.2    
By-Laws of National Mentor Holdings, Inc.
  Incorporated by reference to Exhibit 3.2 of the March 2007 10-Q
       
 
   
  4.1    
Supplemental Indenture #10, dated as of February 22, 2010, by and among National Mentor Holdings, Inc., NeuroRestorative Associates, Inc. and U.S. Bank National Association, as trustee.
  Filed herewith
       
 
   
  4.2    
Supplemental Indenture #11, dated as of April 14, 2010, by and among National Mentor Holdings, Inc., Timber Ridge Group, Inc. and U.S. Bank National Association, as trustee.
  Filed herewith
       
 
   
  31.1    
Certification of principal executive officer.
  Filed herewith
       
 
   
  31.2    
Certification of principal executive officer.
  Filed herewith
       
 
   
  31.3    
Certification of principal financial officer.
  Filed herewith
       
 
   
  32    
Certifications furnished pursuant to 18 U.S.C. Section 1350.
  Filed herewith

 

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