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EX-32 - EXHIBIT 32 - NATIONAL MENTOR HOLDINGS, INC.c11936exv32.htm
EX-31.1 - EXHIBIT 31.1 - NATIONAL MENTOR HOLDINGS, INC.c11936exv31w1.htm
EX-10.2 - EXHIBIT 10.2 - NATIONAL MENTOR HOLDINGS, INC.c11936exv10w2.htm
EX-31.3 - EXHIBIT 31.3 - NATIONAL MENTOR HOLDINGS, INC.c11936exv31w3.htm
EX-31.2 - EXHIBIT 31.2 - NATIONAL MENTOR HOLDINGS, INC.c11936exv31w2.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 December 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
(State or other jurisdiction of
  31-1757086
(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   Smaller reporting company o
        (Do not check if smaller reporting company)    
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 February 14, 2011, there were 100 shares outstanding of the registrant’s common stock, $.01 par value.
 
 

 

 


 

Index
National Mentor Holdings, Inc.
         
    Page  
       
 
       
    3  
     
    3
     
    4
     
    5
     
    6
     
    16
     
    25
     
    26
 
       
       
     
    26
     
    27
     
    37
     
    38
     
    38
     
    38
     
    38
     
    39
 
       
 Exhibit 10.2
 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)
                 
    December 31,     September 30,  
    2010     2010  
Assets
               
Current assets
               
Cash and cash equivalents
  $ 34,536     $ 26,448  
Restricted cash
    873       1,046  
Accounts receivable, net
    124,960       125,979  
Deferred tax assets, net
    13,430       13,571  
Prepaid expenses and other current assets
    12,239       14,701  
 
           
Total current assets
    186,038       181,745  
Property and equipment, net
    140,207       142,112  
Intangible assets, net
    430,116       437,757  
Goodwill
    230,636       229,757  
Other assets
    14,073       13,915  
Investment in related party debt securities
    11,437       10,599  
 
           
Total assets
  $ 1,012,507     $ 1,015,885  
 
           
Liabilities and shareholder’s equity
               
Current liabilities
               
Accounts payable
  $ 18,122     $ 26,503  
Accrued payroll and related costs
    67,301       68,272  
Other accrued liabilities
    54,454       48,307  
Obligations under capital lease, current
    64       92  
Current portion of long-term debt
    3,667       3,667  
 
           
Total current liabilities
    143,608       146,841  
Other long-term liabilities
    15,985       15,166  
Deferred tax liabilities, net
    124,839       126,322  
Obligations under capital lease, less current portion
    1,597       1,624  
Long-term debt, less current portion
    499,883       500,799  
 
           
Total liabilities
    785,912       790,752  
Shareholder’s equity
               
Common stock
           
Additional paid-in-capital
    250,109       250,620  
Other comprehensive income
    782       575  
Accumulated deficit
    (24,296 )     (26,062 )
 
           
Total shareholder’s equity
    226,595       225,133  
 
           
Total liabilities and shareholder’s equity
  $ 1,012,507     $ 1,015,885  
 
           
See accompanying notes.

 

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National Mentor Holdings, Inc.
Condensed Consolidated Statements of Operations
(In thousands)
(Unaudited)
                 
    Three Months Ended  
    December 31,  
    2010     2009  
Net revenue
  $ 266,651     $ 250,215  
Cost of revenue (exclusive of depreciation expense shown below)
    206,164       191,522  
Operating expenses:
               
General and administrative
    34,600       33,286  
Depreciation and amortization
    15,011       14,174  
 
           
Total operating expenses
    49,611       47,460  
 
           
Income from operations
    10,876       11,233  
Other income (expense):
               
Management fee of related party
    (345 )     (276 )
Other income, net
    229       58  
Interest income
    5       12  
Interest income from related party
    494       476  
Interest expense
    (8,146 )     (11,880 )
 
           
Income (loss) from continuing operations before income taxes
    3,113       (377 )
Provision (benefit) for income taxes
    1,344       (502 )
 
           
Income from continuing operations
    1,769       125  
Loss from discontinued operations, net of tax
    (3 )     (165 )
 
           
Net income (loss)
  $ 1,766     $ (40 )
 
           
See accompanying notes.

 

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National Mentor Holdings, Inc.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
                 
    Three Months Ended  
    December 31,  
    2010     2009  
Operating activities
               
Net income (loss)
  $ 1,766     $ (40 )
Adjustments to reconcile net income (loss) to cash provided by operating activities:
               
Accounts receivable allowances
    2,747       2,626  
Depreciation and amortization of property and equipment
    5,772       5,920  
Amortization of other intangible assets
    9,239       8,502  
Amortization of deferred financing costs
    792       791  
Accretion of investment in related party debt securities
    (243 )     (242 )
Stock-based compensation
          114  
Deferred income taxes
    (1,342 )     (2,264 )
(Gain) loss on disposal of assets
    (45 )     50  
Change in fair value of contingent consideration
    222        
Non-cash impairment charge
    (22 )     (62 )
Non-cash interest income from related party
    (251 )     (234 )
Changes in operating assets and liabilities:
               
Accounts receivable
    (1,303 )     (1,449 )
Other assets
    2,173       (162 )
Accounts payable
    (8,399 )     (1,746 )
Accrued payroll and related costs
    (1,069 )     (823 )
Other accrued liabilities
    9,138       5,981  
Other long-term liabilities
    819       509  
 
           
Net cash provided by operating activities
    19,994       17,471  
Investing activities
               
Cash paid for acquisitions, net of cash received
    (2,933 )     (14 )
Purchases of property and equipment
    (3,958 )     (3,930 )
Changes in restricted cash
    173       (848 )
Cash proceeds from sale of assets
    187       131  
Cash proceeds from sale of businesses
    22       39  
 
           
Net cash used in investing activities
    (6,509 )     (4,622 )
Financing activities
               
Repayments of long-term debt
    (916 )     (933 )
Repayments of capital lease obligations
    (55 )     (37 )
Cash paid for earn-out obligations
    (3,313 )      
Payments of deferred financing costs
    (602 )      
Dividend to Parent
    (511 )      
 
           
Net cash used in financing activities
    (5,397 )     (970 )
Net increase in cash and cash equivalents
    8,088       11,879  
Cash and cash equivalents at beginning of period
    26,448       23,650  
 
           
Cash and cash equivalents at end of period
  $ 34,536     $ 35,529  
 
           
See accompanying notes.

 

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National Mentor Holdings, Inc.
Notes to Condensed Consolidated Financial Statements
December 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 health and 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/or 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, which it delivers in home- and community-based settings. Most of the Company’s service plans involve residential support, typically in small group homes, host home settings, or specialized community facilities, designed to improve the clients’ quality of life and to promote their independence and participation in community life. Other services offered include supported living, day and transitional programs, vocational services, case management, family-based services, post-acute treatment and neurorehabilitation, neurobehavioral rehabilitation and physical, occupational and speech therapies, among others. The Company’s customized service plans offer its clients as well as the payors of these services, an attractive, cost-effective alternative to health and human services provided in large, institutional settings.
The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with 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, 2010, 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. Intercompany balances and transactions between the Company and its subsidiaries have been eliminated in consolidation. Operating results for the three months ended December 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 management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
2. Recent Accounting Pronouncements
Presentation of Insurance Claims and Related Insurance Recoveries — In August 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No 2010-24, Health Care Entities (Topic 954), Presentation of Insurance Claims and Related Insurance Recoveries (“ASU 2010-24”), which clarifies that companies should not net insurance recoveries against a related claim liability. Additionally, the amount of the claim liability should be determined without consideration of insurance recoveries. The adoption of ASU 2010-24 is effective for the Company beginning October 1, 2011. With its adoption, the Company’s accounting for insurance recoveries and related claim liability will change on a prospective basis on the date of adoption. The Company is currently evaluating the impact of this guidance on its financial statements.
3. Comprehensive Income
The components of comprehensive income and related tax effects are as follows:
                 
    Three Months Ended  
    December 31,  
(in thousands)   2010     2009  
Net income (loss)
  $ 1,766     $ (40 )
Changes in unrealized gain on derivatives net of taxes of $0 and $1,162
          1,714  
Changes in unrealized gain on available-for-sale debt securities net of taxes of $137 and $250
    207       367  
 
           
 
               
Comprehensive income
  $ 1,973     $ 2,041  
 
           

 

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4. Long-Term Debt
The Company’s long-term debt consists of the following:
                 
    December 31,     September 30,  
(in thousands)   2010     2010  
Senior term B loan, principal and interest due in quarterly installments through June 29, 2013
  $ 319,925     $ 320,763  
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 December 31, 2010 and September 30, 2010)
    3,625       3,703  
 
           
 
    503,550       504,466  
Less current portion
    3,667       3,667  
 
           
Long-term debt
  $ 499,883     $ 500,799  
 
           
Senior secured credit facilities
The senior secured credit facilities were repaid and replaced with new senior secured credit facilities on February 9, 2011. See “Note 12. Subsequent Events”.
The Company’s senior secured 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 secured credit facilities are guaranteed by the Company’s subsidiaries and are secured by substantially all of the Company’s assets.
Total cash paid for interest on the Company’s debt amounted to $2.3 million and $6.0 million for the three months ended December 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. At December 31, 2010, the variable interest rate on the term B loan was 2.27%.
Senior revolver and synthetic letter of credit facility
The Company had no borrowings and $109.1 million of availability under the $125.0 million senior revolver as of December 31, 2010. The Company had $35.9 million in standby letters of credit outstanding as of December 31, 2010 related to the Company’s workers’ compensation insurance coverage. Of these letters of credit, $20.0 million was issued under the Company’s synthetic letter of credit facility, and $15.9 million was 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 other than non-profit subsidiaries.
Approximately $171.9 million of the senior subordinated notes were purchased on February 9, 2011 pursuant to a tender offer and consent solicitation for the senior subordinated notes. See “Note 12. Subsequent Events”.

 

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Mortgage facility
The mortgage facility was repaid on February 9, 2011. See “Note 12. Subsequent Events”.
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 mortgage facility balance has been classified as long-term debt. The mortgage facility is secured by certain buildings and land of the Company.
Covenants
Prior to February 9, 2011, the senior credit agreement and the indenture governing the senior subordinated notes contained 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.
The Company was restricted from paying dividends to NMH Holdings, LLC (“Parent”) in excess of $15.0 million, except for dividends used for the repurchase of equity from former officers and employees and for the payment of management fees, taxes, and certain other expenses.
5. Business Combinations
The operating results of the businesses acquired during the three months ended December 31, 2010 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 value of net tangible assets was allocated to specifically identified intangible assets, with the residual being allocated to goodwill.
During the three months ended December 31, 2010, the Company acquired three companies complementary to its business for total fair value consideration of $2.9 million:
New Start Homes On October 1, 2010, the Company acquired the assets of New Start Homes, Inc. (“New Start Homes”) for total cash of $0.7 million. New Start Homes operates in California and provides residential and rehabilitation services to individuals with acquired brain injuries in group home facilities. As a result of this acquisition, the Company recorded $0.2 million of goodwill in the Post-Acute Specialty Rehabilitation Services segment, which is expected to be deductible for tax purposes. The acquired intangibles assets included $0.4 million of agency contracts with a weighted average useful life of eleven years. The remaining purchase price was allocated to tangible assets.
ViaQuest On October 26, 2010, the Company acquired the assets of ViaQuest Behavorial Health of Pennsylvannia, LLC (“ViaQuest”) for total cash of $1.1 million. ViaQuest provides residential and periodic services to individuals with behavioral health issues. As a result of the ViaQuest acquisition, the Company recorded $0.3 million of goodwill in the Human Services segment, which is expected to be deductible for tax purposes. The acquired intangibles assets included $0.6 million of agency contracts with a weighted average useful life of ten years. The remaining purchase price was allocated to tangible assets and liabilities.
Phoenix Homes On December 31, 2010, the Company acquired the assets of Phoenix Homes, Inc. (“Phoenix Homes”) for total consideration of $1.1 million. Phoenix Homes is a licensed child-placing agency that provides community-based, family focused therapeutic foster care to families and children in crisis or at risk in Maryland and Rhode Island. As a result of this acquisition, the Company recorded $0.5 million of goodwill in the Human Services segment, which is expected to be deductible for tax purposes. The acquired intangibles assets included $0.6 million of agency contracts with a weighted average useful life of ten years.

 

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The following table summarizes the amounts (from all three acquisitions) of identifiable assets acquired and liabilities assumed at the date of the acquisition:
       
(In thousands)
       
Accounts receivable
  $ 279  
Other assets, current and long term
    55  
Identifiable intangible assets
    1,598  
Property and equipment
    51  
Accounts payable and accrued expenses
    (116)  
 
     
Total identifiable net assets
    1,867  
Goodwill
    1,066  
 
     
 
  $ 2,933  
 
     
Pro forma Results of Operations
The unaudited pro forma results of operations provided below for the three months ended December 31, 2010 is presented as though the acquisitions had occurred at the beginning of the 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. The Company has determined that the presentation of the results of operations for each of these acquisitions, from the date of acquisition, is impracticable due to the integration of the operations upon acquisition.
         
    Three Months Ended  
    December 31, 2010  
(In thousands)
       
Net revenue
  $ 274,570  
Income from operations
    11,946  
Contingent consideration
Authoritative guidance has recently been updated governing the requirements for the recognition and measurement of contingent consideration at its fair value on the acquisition date. The Company is required to remeasure the fair value of an earn-out at each reporting date until the contingency is resolved and changes to the fair value are recognized in earnings in the period of the change. The Company adopted this guidance on October 1, 2009 and the statement applies prospectively for business combinations incurred on or after that date.
Springbrook On January 15, 2010, the Company acquired the assets of Springbrook, Inc. and an affiliate (together, “Springbrook”) for total fair value consideration of $9.3 million, subject to increase based on an earn-out. The earn-out provided that an additional $3.5 million in cash could be paid based upon the purchased entity’s achieving certain earnings targets (the “earn-out”). The fair value of the earn-out on the date of acquisition was $1.6 million and the fair value of the earn-out at September 30, 2010 was $3.0 million, with the difference of $1.4 million being recognized as a charge to earnings. During the three months ended December 31, 2010, the Company recorded an additional $0.2 million to the contingent consideration obligation as a result of adjustments to the forecasted financial performance of Springbrook. The increase in contingent consideration is included in general and administrative expenses in the consolidated statements of operations.
IFCS On June 1, 2009, the Company acquired the stock of Institute for Family Centered Services, Inc. (“IFCS”) for total cash of $11.5 million. This acquisition took place prior to the October 1, 2009 change in authoritative guidance. Accordingly, during fiscal 2010, when the Company accrued an additional $3.3 million of expected earn-out which was paid during the three months ended December 31, 2010 the offset to the payment was “Goodwill”. During the three months ended December 31, 2010, the Company accrued an additional $0.2 million of expected earn-out which was also recorded as an adjustment to Goodwill in the consolidated balance sheet.

 

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6. Goodwill and Intangible Assets
Goodwill
The changes in goodwill for the three months ended December 31, 2010 are as follows:
                         
            Post Acute        
            Specialty        
    Human     Rehabilitation        
(In thousands)   Services     Services     Total  
Balance as of September 30, 2010
    169,885       59,872       229,757  
Goodwill acquired through acquisitions
    829       237       1,066  
Adjustments to goodwill, net
    170       (357 )     (187 )
 
                 
Balance as of December 31, 2010
  $ 170,884     $ 59,752     $ 230,636  
 
                 
The adjustments to goodwill relate to the finalization of the purchase price for acquisitions during the measurement period.
Intangible Assets
Intangible assets consist of the following as of December 31, 2010:
                         
    Gross              
    Carrying     Accumulated     Intangible  
Description   Value     Amortization     Assets, Net  
(In thousands)              
Agency contracts
  $ 467,277     $ 120,970     $ 346,307  
Non-compete/non-solicit
    1,044       456       588  
Relationship with contracted caregivers
    12,804       6,406       6,398  
Trade names
    4,039       1,569       2,470  
Trade names
    47,700             47,700  
Licenses and permits
    42,713       16,760       25,953  
Intellectual property
    904       204       700  
 
                 
 
  $ 576,481     $ 146,365     $ 430,116  
 
                 
Intangible assets consist of the following as of September 30, 2010:
                         
    Gross              
    Carrying     Accumulated     Intangible  
Description   Value     Amortization     Assets, Net  
(In thousands)              
Agency contracts
  $ 465,679     $ 113,418     $ 352,261  
Non-compete/non-solicit
    1,044       403       641  
Relationship with contracted caregivers
    12,804       5,977       6,827  
Trade names
    4,039       1,463       2,576  
Trade names
    47,700             47,700  
Licenses and permits
    42,713       15,693       27,020  
Intellectual property
    904       172       732  
 
                 
 
  $ 574,883     $ 137,126     $ 437,757  
 
                 
Amortization expense for the three months ended December 31, 2010 and 2009 was $9.2 million and $8.4 million, respectively.
7. Related Party Transactions
Management Agreements
On June 29, 2006, the Company entered into a management agreement with Vestar Capital Partners V, L.P. (“Vestar”) relating to certain advisory and consulting services for an annual management fee equal to the greater of (i) $850 thousand or (ii) an amount equal to 1.0% of the Company’s consolidated earnings before interest, taxes, depreciation, amortization and management fee for each fiscal year determined as set forth in the Company’s senior credit agreement.

 

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As part of the management agreement, the Company agreed to indemnify Vestar and its affiliates from and against all losses, claims, damages and liabilities arising out of the performance by Vestar of its services pursuant to the management agreement. The management agreement will terminate upon such time that Vestar and its partners and their respective affiliates hold, directly or indirectly in the aggregate, less than 20% of the voting power of the outstanding voting stock of the Company. This agreement was amended and restated effective February 9, 2011. See “Note 12. Subsequent Events”. During both the three months ended December 31, 2010 and 2009, the Company expensed $0.3 million of management fees and expenses under such agreement.
Consulting Agreements
During fiscal 2010, the Company engaged Alvarez & Marsal Healthcare Industry Group to provide certain transaction advisory and other services. The Company’s director, Guy Sansone, is a Managing Director at Alvarez & Marsal and the head of its Healthcare Industry Group. The engagement resulted in aggregate fees of $0.6 million for the three months ended December 31, 2010 and was approved by the Company’s Audit Committee. Mr. Sansone is not a member of the Company’s Audit Committee and was not personally involved in the engagement.
The Company engaged Duff & Phelps, LLC as a financial advisor in connection with the refinancing transactions, including the repurchase of the Senior Floating Rate Toggle Notes due 2014 (the “NMH Holdings notes”), and related matters. According to public filings, Vestar owns 12.4% of the Class A common stock of Duff & Phelps Corporation, the parent company of Duff & Phelps, LLC, and one of its principals serves on the Board of Directors of Duff & Phelps Corporation but has not been personally involved in this engagement. This engagement is expected to result in aggregate fees of approximately $0.2 million during fiscal 2011 and was approved by the Company’s Board of Directors, with the Vestar members abstaining from voting.
Lease Agreements
The Company leases several offices, homes and other facilities from its employees, or from relatives of employees, primarily in the states of California, Nevada and Arkansas, 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 $1.2 million and $1.0 million for the three months ended December 31, 2010 and 2009, respectively.
Investment in Related Party Debt Securities
During fiscal 2009, the Company purchased $11.5 million in aggregate principal amount of the NMH Holdings notes issued by NMH Holdings, Inc. (“NMH Holdings”), the Company’s indirect parent company, for $6.6 million. The security was and continues to be classified as an available-for-sale debt security and recorded on the Company’s 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. The Company recorded interest income related to the NMH Holdings notes of $0.5 million for both the three months ended December 31, 2010 and 2009. This interest income is recorded under Interest income from related party in the consolidated statements of operations and includes PIK Interest as well as the accretion of the purchase discount on the securities. Total PIK Interest included in the balance of available-for-sale debt security totaled $2.0 million as of December 31, 2010.

 

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As of December 31, 2010, the Company’s investment in related-party debt securities had a carrying value of $10.1 million, and an approximate fair value of $11.4 million which is reflected on the Company’s consolidated balance sheets as Investment in related party debt securities. As a result, the Company has recorded $1.3 million of unrealized holding gain in accumulated other comprehensive income, $0.3 million of which was recorded during the three months ended December 31, 2010. NMH Holdings purchased the NMH Holdings notes held by the Company on February 9, 2011 pursuant to a tender offer and consent solicitation for the NMH Holdings notes. See “Note 12. Subsequent Events”.
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 at December 31, 2010.
8. Fair Value Measurements
The Company measures and reports its financial and non-financial assets and liabilities on the basis of fair value. 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 at December 31, 2010 consist of:
                                 
            Quoted     Significant Other     Significant  
            Market Prices     Observable Inputs     Unobservable Inputs  
    Total     (Level 1)     (Level 2)     (Level 3)  
                    (In thousands):          
Cash equivalents
  $ 31,500     $ 31,500     $     $  
Investment in related party debt securities
  $ 11,437     $     $ 11,437     $  
Contingent consideration
  $ (3,263 )   $     $     $ (3,263 )
Assets and liabilities recorded at fair value on a recurring basis at September 30, 2010 consist of:
                                 
            Quoted     Significant Other     Significant  
            Market Prices     Observable Inputs     Unobservable Inputs  
    Total     (Level 1)     (Level 2)     (Level 3)  
                    (In thousands):          
Cash equivalents
  $ 15,500     $ 15,500     $     $  
Investment in related party debt securities
  $ 10,599     $     $ 10,599     $  
Contingent consideration
  $ (3,041 )   $     $     $ (3,041 )

 

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Cash equivalents. Cash equivalents consist primarily of money market funds and the carrying value of cash equivalents approximates fair value.
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 earn-out associated with the fiscal 2010 acquisitions 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.
The following table provides a reconciliation of the beginning and ending balances for the liability measured at fair value using significant unobservable inputs (Level 3).
         
    Due to Seller  
Balance at September 30, 2010
  $ (3,041 )
Change in fair value of contingent consideration
    (222 )
 
     
Balance at December 31, 2010
  $ (3,263 )
 
     
At December 31, 2010, the carrying values of cash, accounts receivable and accounts payable approximated fair value. The carrying value and fair value of the Company’s debt instruments are set forth below:
                                 
    December 31, 2010     September 30, 2010  
    Carrying     Fair     Carrying     Fair  
    Amount     Value     Amount     Value  
            (In thousands):          
Senior subordinated notes
  $ 180,000     $ 183,600     $ 180,000     $ 184,050  
The Company estimated the fair value of the debt instruments using market quotes and calculations based on current market rates available.
On February 9, 2011, the Company repurchased $171.9 million of the senior subordinated notes pursuant to a tender offer and consent solicitation for the senior subordinated notes. See “Note 12. Subsequent Events”.
9. Income Taxes
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 December 31, 2010, the Company’s effective income tax rate was 43.2% compared to an effective tax rate of 133.2% for the three months ended December 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.
NMH Holdings files a federal consolidated return and files various state income tax returns. The Company files various state income tax returns and, generally, is no longer subject to income tax examinations by the taxing authorities for years prior to September 30, 2003. The Company’s reserve for uncertain income tax positions at December 31, 2010 is $4.9 million. There has been no change in unrecognized tax benefits in the three months ended December 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 charges to income tax expense.

 

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10. Segment Information
The Company has two reportable segments, Human Services and Post-Acute Specialty Rehabilitation Services (“SRS”).
The Human Services segment delivers home and community-based human services to adults and children with intellectual and/or developmental disabilities and to youth with emotional, behavioral and/or 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 delivers health care and community-based health and human services to individuals who have suffered acquired brain, spinal 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 December 31,   Services     Services     Corporate     Consolidated  
2010                                
Net revenue
  $ 223,351     $ 43,300     $     $ 266,651  
Income (loss) from operations
    20,299       4,858       (14,281 )     10,876  
Total assets
    792,349       156,454       63,704       1,012,507  
Depreciation and amortization
    10,870       2,993       1,148       15,011  
2009
                               
Net revenue
  $ 221,579     $ 28,636     $     $ 250,215  
Income (loss) from operations
    20,075       3,132       (11,974 )     11,233  
Depreciation and amortization
    11,058       1,952       1,164       14,174  
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.
Until September 30, 2010, the Company insured professional and general liability through its captive insurance subsidiary amounts of up to $1.0 million per claim and up to $2.0 million in the aggregate. Commencing October 1, 2010, the Company is self-insured for $2.0 million per claim and $8.0 million in the aggregate, and for $500 thousand per claim in excess of the aggregate. In connection with the Merger on June 29, 2006, subject to the $1.0 million per claim and up to $2.0 million in the aggregate 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.
During fiscal 2010, the Company’s wholly-owned subsidiary captive insurance company provided 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 were fully consolidated with those of the other operations of the Company in the Company’s consolidated financial statements for fiscal 2010. Effective September 30, 2010, the captive insurance subsidiary was dissolved and the Company is no longer self-insured through the captive subsidiary on the effective date.

 

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The Company is in the health and human services business and, therefore, has been and continues to be subject to substantial claims alleging that the Company, its employees or its independently contracted host-home caregivers (“Mentors”) failed to provide proper care for a client. The Company is also subject to claims by its clients, its employees, its Mentors or community members against the Company for negligence, intentional misconduct or violation of applicable laws. 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 reserves for costs related to contingencies when a loss is probable and the amount is reasonably estimable. While the Company believes the provision for legal contingencies is adequate, the outcome of the legal proceedings is difficult to predict and the Company may settle legal claims or be subject to judgments for amounts that differ from the Company’s estimates.
12. Subsequent Events
Business Combinations
Subsequent to December 31, 2010, the Company acquired two companies complimentary to its business for total aggregate consideration of $0.5 million.
Refinancing Transactions
On February 9, 2011, the Company entered into a new senior credit agreement for new senior secured credit facilities (the “new senior secured credit facilities”) consisting of a six-year $530.0 million term loan facility, of which $50.0 million was deposited in a cash collateral account in support of issuance of letters of credit under an institutional letter of credit facility, and a $75.0 million five-year senior secured revolving credit facility. All of the Company’s obligations under the new senior secured credit facilities are guaranteed by Parent and certain of the Company’s existing subsidiaries. The obligations under the new senior secured credit facilities are secured by a pledge of 100% of the Company’s capital stock and the capital stock of domestic subsidiaries owned by the Company and any other domestic subsidiary guarantor and 65% of the capital stock of any first tier foreign subsidiaries, and a security interest in substantially all of the tangible and intangible assets of Parent, the Company and each subsidiary guarantor.
In addition, on February 9, 2011, the Company issued $250.0 million in aggregate principal amount of its 12.5% senior notes due 2018 (the “senior notes”). The senior notes were sold at a price equal to 97.737% of their face value. The senior notes pay interest semi-annually on February 15 and August 15 of each year, beginning on August 15, 2011. The senior notes are unsecured obligations of the Company and are fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by certain of the Company’s existing subsidiaries.

 

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The Company used the net proceeds from the new senior secured credit facilities and the senior notes, together with cash on hand, to: (i) repay all amounts owing under the Company’s old senior secured credit facilities and the Company’s mortgage facility; (ii) purchase $171.9 million of the senior subordinated notes; (iii) pay a $229.3 million dividend to Parent, which in turn made a distribution to NMH Holdings, which used the proceeds of the distribution to repurchase $210.9 million of the NMH Holdings notes; and (iv) pay related fees and expenses. NMH Holdings also repurchased $13.5 million of NMH Holdings notes held by the Company.
Therefore, as of February 9, 2011, the Company has increased its outstanding debt by $277.4 million and decreased its equity when compared to the December 31, 2010 balance sheet.
Management Agreement
The management agreement with Vestar was amended and restated on February 9, 2011 to provide for the payment of reasonable and customary fees to Vestar for services in connection with a sale of the Company, an initial public offering by or involving NMH Investment or any of its subsidiaries or any extraordinary acquisition by or involving NMH Investment or any of its subsidiaries; provided, that such fees shall only be paid with the consent of the directors of the Company who are not affiliated with or employed by Vestar. See “Note 7. Related Party Transactions” for additional information.
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 our Annual Report on Form 10-K for the fiscal year ended September 30, 2010, as well as our reports on Forms 10-Q and 8-K and other publicly available information. 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
We are a leading provider of home and community-based health and human services to adults and children with intellectual and/or developmental disabilities (“I/DD”), acquired brain injury (“ABI”) and other catastrophic injuries and illnesses, and to youth with emotional, behavioral and/or medically complex challenges, or at-risk youth (“ARY”). Since our founding in 1980, we have grown to provide services to approximately 24,000 clients in 36 states.
We design customized service plans to meet the unique needs of our clients, which we deliver in home and community-based settings. Most of our service plans involve residential support, typically in small group homes, host home settings or specialized community facilities, designed to improve our clients’ quality of life and to promote client independence and participation in community life. Other services offered include supported living, day and transitional programs, vocational services, case management, family-based services, post-acute treatment and neurorehabilitation, neurobehavioral rehabilitation and physical, occupational and speech therapies, among others. Our customized service plans offer our clients, as well as the payors for these services, an attractive, cost-effective alternative to health and human services provided in large, institutional settings.
We offer our services through a variety of models, including (i) small group homes, most of which are residences for six people or fewer, (ii) host homes, or the “Mentor” model, in which a client lives in the home of a trained Mentor, (iii) in-home settings, in which we support clients’ independence with 24-hour services in their own homes, (iv) small, specialized community facilities which provide post-acute, specialized rehabilitation and comprehensive care for individuals who have suffered ABI, spinal injuries and other catastrophic injuries and illnesses and (v) non-residential settings, consisting primarily of day programs and periodic services in various settings.
Delivery of services to adults and children with I/DD is the largest portion of our Human Services segment. Our I/DD programs include residential support, day habilitation, vocational services, case management and personal care. Our Human Services segment also includes the delivery of ARY services. Our ARY programs include therapeutic foster care, family reunification, family preservation, early intervention and adoption services. Our Post-Acute Specialty Rehabilitation Services (“SRS”) segment delivers healthcare and community-based human services to individuals who have suffered ABI, spinal injuries and other catastrophic injuries and illnesses. Our services range from sub-acute healthcare for individuals with intensive medical needs to day treatment programs, and include skilled nursing, neurorehabilitation, neurobehavioral rehabilitation, physical, occupational, and speech therapy, supported living, outpatient treatment, and pre-vocational services.

 

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We have two reportable segments, Human Services and 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/or medically complex challenges. The SRS segment provides a mix of health care and community-based health and human services to individuals who have suffered ABI, spinal injuries and other catastrophic injuries and illnesses.
Factors Affecting our Operating Results
Demand for Home and Community-Based Health and 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 Post-Acute Specialty Rehabilitation Services has also grown as faster emergency response and improved medical techniques have resulted in more people surviving a catastrophic injury, as well as spinal cord and other catastrophic injuries. SRS services are increasingly sought out as a clinically-appropriate and less-expensive alternative to institutional care and “step-down” for individuals who no longer require care in acute settings.
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. 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.
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, although we have suffered rate reductions in the current recessionary environment. 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. The majority of our specialty rehabilitation services revenue, however, is derived from non-public payors, such as commercial insurers, managed care and other private payors.
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 programs in new and existing geographic markets (which we refer to as “new starts”) typically require us to fund operating losses for a period of approximately 18 to 24 months. If a new start does not become profitable during such period, we may terminate it. During the twelve months ended December 31, 2010, operating losses on new starts for programs started within the previous 18 months were $2.1 million.

 

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Acquisitions
As of December 31, 2010, we have completed 29 acquisitions since 2005, 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.
During the three months ended December 31, 2010, we acquired three companies complementary to our business for total fair value consideration of $2.9 million. The following acquisitions are included in the Human Services segment during three months ended December 31, 2010:
ViaQuest On October 26, 2010, we acquired the assets of ViaQuest Behavorial Health of Pennsylvannia, LLC (“ViaQuest”) for total cash of $1.1 million. ViaQuest provides residential and periodic services to individuals with behavioral health issues.
Phoenix Homes On December 31, 2010, we acquired the assets of Phoenix Homes, Inc. (“Phoenix Homes”) for total consideration of $1.1 million. Phoenix Homes is a licensed child-placing agency that provides community-based, family focused therapeutic foster care to families and children in crisis or at risk in Maryland and Rhode Island.
In addition, the following acquisition is included in the SRS segment.
New Start Homes On October 1, 2010, we acquired the assets of New Start Homes, Inc. (“New Start Homes”) for total cash of $0.7 million. New Start Homes operates in California and provides residential and rehabilitation services to individuals with acquired brain injuries in group home facilities.
For additional information on the acquisitions made during three months ended December 31, 2010, see See “Note 5. Business Combinations” to our consolidated financial statements included elsewhere in this report.
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. Revenue is also reported net of any state provider taxes or gross receipts taxes levied on services we provide. For the three months ended December 31, 2010, we derived approximately 90% of our net revenue from state and local government payors and approximately 10% of our net revenue from non-public payors. Substantially all of our non-public revenue is generated by our SRS business through contracts with commercial insurers, workers’ compensation carriers and other private 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. Reserves are provided when estimable and probable. 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.
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.

 

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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 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 paid 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 December 31, 2010, we owned 402 facilities and one office, and we leased 944 facilities and 273 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 1.0% and 0.5% of our net revenue for the three months ended December 31, 2010 and 2009, respectively. We have incurred professional and general liability claims and insurance expense for professional and general liability of $2.7 million and $1.1 million for the three months ended December 31, 2010 and 2009, respectively. Claims paid by us and our insurers for professional and general liability have increased sharply in recent years. We have historically self-insured amounts of up to $1.0 million per claim and up to $2.0 million in the aggregate. Commencing October 1, 2010, we pay substantially higher premiums for our professional and general liability policies, and our self-insured retentions substantially exceed the amounts we previously had. Since October 1, 2010, we have had self-insured retentions for $2.0 million per claim and $8.0 million in the aggregate, and for $500 thousand per claim in excess of the aggregate.
During fiscal 2010, our wholly-owned subsidiary captive insurance company provided coverage for our self-insured portion of professional and general liability claims and our employment practices liability. The accounts of the captive insurance company were fully consolidated with those of our other operations in our consolidated financial statements for fiscal 2010. Effective September 30, 2010, the captive insurance subsidiary was dissolved and we are no longer self-insured through the captive subsidiary on the effective date.
Our ability to maintain our margin in the future is dependent upon obtaining increases in rates and/or controlling our expenses. In fiscal 2008, 2009 and 2010, we invested in infrastructure initiatives and business process improvements, which had a net negative impact on our margin.
Results of Operations
The following table sets forth income (loss) from operations as a percentage of net revenue for the periods indicated:
                                 
            Post Acute Specialty              
For the Three Months Ended December 31,   Human Services     Rehabilitation Services     Corporate     Consolidated  
(In thousands)
                               
2010
                               
Net revenue
  $ 223,351     $ 43,300     $     $ 266,651  
Income (loss) from operations
    20,299       4,858       (14.281 )     10,876  
Operating margin
    9.1 %     11.2 %           4.1 %
2009
                               
Net revenue
  $ 221,579     $ 28,636     $     $ 250,215  
Income (loss) from operations
    20,075       3,132       (11,974 )     11,233  
Operating margin
    9.1 %     10.9 %           4.5 %

 

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Three months ended December 31, 2010 compared to three months ended December 31, 2009
Consolidated
Consolidated revenue for the three months ended December 31, 2010 increased by $16.4 million, or 6.6%, compared to revenue for the three months ended December 31, 2009. Revenue increased $14.5 million related to acquisitions that closed during fiscal 2010 and the three months ended December 31, 2010 and $1.9 million related to organic growth, including growth related to new programs. Organic growth increased despite the negative impact of rate reductions in several states, including Indiana (5%) and Wisconsin (individual, client-specific adjustments).
Consolidated income from operations decreased from $11.2 million for the three months ended December 31, 2009 to $10.9 million for the three months ended December 31, 2010 and operating margin decreased from 4.5% of revenue to 4.1% of revenue for the same period. The operating margin was negatively impacted by rate reductions in several states, including Indiana and Wisconsin.
In addition, our operating margin was negatively impacted by our higher self-insured retentions and premiums for professional and general liability policies. During the three months ended December 31, 2010, we recorded an additional $1.4 million related to professional and general liability expense.
During the three months ended December 31, 2010, we recorded an additional $0.8 million related to our cost structure optimization efforts, an additional $0.6 million in consulting and legal costs related to a transaction which was not completed and $0.2 million of expense related to a contingent earn-out adjustment from the Springbrook acquisition.
Income from operations was positively impacted by an increase in revenue noted above, as well as an expense reduction from our on-going cost containment efforts.
Depreciation and amortization expense increased $0.8 million during the three months ended December 31, 2010 due to an increase in amortizable assets resulting from acquisitions in the period.
Interest expense for the three months ended December 31, 2010 decreased $3.7 million to $8.1 million due to a decrease in the average debt balance as well as a decrease in the weighted average interest rate from 8.2% during the three months ended December 31, 2009 to 5.5% during the three months ended December 31, 2010, in part resulting from the expiration of our interest rate swaps.
Human Services
Human Services revenue for the three months ended December 31, 2010 increased by $1.8 million, or 0.8%, compared to the three months ended December 31, 2009. Revenue increased $3.1 million related to acquisitions that closed during fiscal 2010 and the three months ended December 31, 2010 while revenue from existing programs decreased $1.3 million due to rate reductions in several states, including Indiana and Wisconsin.
Income from operations increased from $20.1 million during the three months ended December 31, 2009 to $20.3 million during the three months ended December 31, 2010 while our operating margin remained constant at 9.1% for these periods. Income from operations was positively impacted by expense reduction from our ongoing cost-containment efforts. Partially offsetting this was an increase in expense related to our higher self-insured retentions and premiums for professional and general liability policies. During the three months ended December 31, 2010, we recorded an additional $1.2 million related to professional and general liability expense. Operating margin was also negatively impacted by rate reductions in several states, including Indiana and Wisconsin.
Post-Acute Specialty Rehabilitation Services
Post-Acute Specialty Rehabilitation Services revenue for the three months ended December 31, 2010 increased by $14.6 million, or 51.2%, compared to the three months ended December 31, 2009. This increase was due to growth of $11.4 million related to acquisitions that closed during fiscal 2010 and the three months ended December 31, 2010 and $3.2 million related to organic growth, including growth related to new programs.
Income from operations increased from $3.1 million for the three months ended December 31, 2009 to $4.9 million for the three months ended December 31, 2010, while operating margin increased from 10.9% to 11.2% for the same period.

 

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Corporate
Total corporate expenses increased by $2.3 million from the three months ended December 31, 2009 to $14.3 million for the three months ended December 31, 2010. During the three months ended December 31, 2010, we recorded an additional $0.8 million related to our cost structure optimization efforts, an additional $0.6 million in consulting and legal costs related to a transaction which was not completed and $0.2 million of expense related to a contingent earn-out adjustment from the Springbrook acquisition.
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 new senior revolver (as defined below).
Operating activities
Cash flows provided by operating activities for the three months ended December 31, 2010 were $20.0 million compared to $17.5 million for the three months ended December 31, 2009. The increase was primarily due to an increase in operating income. Our days sales outstanding decreased one day from 47 days at September 30, 2010 to 46 days at December 31, 2010.
Investing activities
Net cash used in investing activities, primarily consisting of cash paid for acquisitions and purchases of property and equipment, was $6.5 million for the three months ended December 31, 2010 compared to $4.6 million for the three months ended December 31, 2009.
Cash paid for acquisitions was $2.9 million for the three months ended December 31, 2010 and included cash paid for three acquisitions, including, New Start Homes, ViaQuest and Phoenix Homes. Cash paid for property and equipment for the three months ended December 31, 2010 was $4.0 million, or 1.5% of revenue and cash paid for property and equipment for the three months ended December 31, 2009 was $3.9 million, or 1.6% of revenue.
Financing activities
Net cash used in financing activities was $5.4 million for the three months ended December 31, 2010 compared to $1.0 million for the three months ended December 31, 2009. Our financing activities for both periods included the repayment of long term debt of $0.9 million.
Net cash used in financing activities for the three months ended December 31, 2010 included an earn-out payment of $3.3 million for the IFCS acquisition, which we acquired in fiscal 2009.
During the three months ended December 31, 2010, we paid $0.6 million in deferred debt financing costs related to the refinancing transactions that we completed on February 9, 2011. Also during the three months ended December 31, 2010, we paid a dividend of $0.5 million to Parent, which used the proceeds of the dividend to make a distribution to NMH Holdings, which in turn used the proceeds of the distribution to pay a dividend of $0.5 million to NMH Investment. NMH Investment used the proceeds of the dividend to repurchase its common equity units from three employees upon their departures
Our principal sources of funds are cash flows from operating activities and available borrowings under our new senior revolver (as defined below). We believe that these funds will provide sufficient liquidity and capital resources to meet our financial obligations for the next twelve months, including scheduled principal and interest payments, as well as to provide funds for working capital, acquisitions, capital expenditures and other needs. No assurance can be given, however, that this will be the case.
Debt and Financing Arrangements
As of December 31, 2010, we had approximately $503.6 million of indebtedness, consisting of $319.9 million of indebtedness under our old senior secured term B loan facility, $180.0 million principal amount of our 11.25% Senior Subordinated Notes due 2014 (the “senior subordinated notes”) and $3.6 million outstanding under out mortgage facility. As of December 31, 2010, we did not have any borrowings under our old senior revolving credit facility (the “old senior revolver”). The availability on the old senior revolver as of December 31, 2010 was reduced by $15.9 million to $109.1 million as letters of credit in excess of $20.0 million under our old synthetic letters of credit facility were outstanding.

 

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As of December 31, 2010, our indirect parent company, NMH Holdings, had $224.4 million aggregate principal amount of the NMH Holdings notes outstanding (including the $13.5 million of which was held by us). These notes were not guaranteed by the Company.
On February 9, 2011, we completed refinancing transactions, which included entering into a new senior credit agreement (the “new senior credit agreement”) for new senior secured credit facilities (the “new senior secured credit facilities”) and issuing $250.0 million in aggregate principal amount of 12.5% senior notes due 2018 (the “senior notes”). We used the net proceeds from the new senior secured credit facilities and the senior notes, together with cash on hand, to: (i) repay all amounts owing under our old senior secured credit facilities and our mortgage facility; (ii) purchase $171.9 million of our senior subordinated notes; (iii) pay a $229.3 million dividend to NMH Holdings, LLC (“Parent”), which in turn made a distribution to NMH Holdings, which used the proceeds of the distribution to repurchase $210.9 million of the NMH Holdings notes; and (iv) pay related fees and expenses. NMH Holdings also repurchased $13.5 million of NMH Holdings notes held by us.
Therefore, as of February 9, 2011, we have increased our outstanding debt by $277.4 million and decreased our equity when compared to the December 31, 2010 balance sheet.
New Senior Secured Credit Facilities
On February 9, 2011, we entered into a new senior credit agreement with UBS AG, Stamford Branch, as administrative agent, and the lenders named therein, for the new senior secured credit facilities, consisting of a six-year $530.0 million term loan facility, of which $50.0 million was deposited in a cash collateral account in support of issuance of letters of credit under an institutional letter of credit facility (the “institutional letter of credit facility”), and a $75.0 million five-year senior secured revolving credit facility (the “new senior revolver”). All of our obligations under the new senior secured credit facilities are guaranteed by NMH Holdings, LLC (“Parent”) and certain of our existing subsidiaries. The obligations under the new senior secured credit facilities are secured by a pledge of 100% of our capital stock and the capital stock of domestic subsidiaries owned by us and any other domestic subsidiary guarantor and 65% of the capital stock of any first tier foreign subsidiaries, and a security interest in substantially all of our tangible and intangible assets and the tangible and intangible assets of Parent and each guarantor.
The new senior revolver includes borrowing capacity available for letters of credit and for borrowings on same-day notice, referred to as the “swingline loans.” Any issuance of letters of credit or making of a swingline loan will reduce the amount available under the new senior revolver. On February 9, 2011, we borrowed $900,000 under the new senior revolver and had $74.1 million of availability under the new senior revolver. As of February 9, 2011, we had $36.4 million of letters of credit issued under the institutional letter of credit facility.
At our option, we may add one or more new term loan facilities or increase the commitments under the new senior revolver (collectively, the “incremental borrowings”) in an aggregate amount of up to $125.0 million so long as certain conditions, including a consolidated leverage ratio (as defined in the new senior credit agreement) of not more than 6.00 to 1.00 on a pro forma basis, are satisfied. The covenants in the indenture governing the senior notes effectively limit the amount of incremental borrowings that we may incur to not more than $75.0 million.
Borrowings under the new senior secured credit facilities bear interest, at our option, at: (i) a rate equal to the greater of (a) the prime rate of UBS AG, Stamford Branch, (b) the federal funds rate plus 1/2 of 1% and (c) the Eurodollar rate for an interest period of one-month beginning on such day plus 100 basis points, plus 4.25%; or (ii) the Eurodollar rate (provided that the rate shall not be less than 1.75% per annum), plus 5.25%. We are also required to pay a commitment fee to the lenders under the new senior revolver at an initial rate of 0.50% of the average daily unutilized commitments thereunder. We must also pay customary letter of credit fees, including a fronting fee as well as administration fees. As of February 9, 2011, borrowings under the senior secured credit facilities bore interest at a weighted average rate of 7.0%.
The new senior credit agreement requires us to make mandatory prepayments, subject to certain exceptions, with: (i) beginning in fiscal 2011, 50% (which percentage will be reduced upon our achievement of certain leverage ratios) of our annual excess cash flow (provided that for fiscal 2011, excess cash flow will only be calculated from April 1, 2011 through September 30, 2011); (ii) 100% of net cash proceeds of all non-ordinary course assets sales or other dispositions of property, subject to certain exceptions; and (iii) 100% of the net cash proceeds of any debt incurrence, other than proceeds from the senior notes and other debt permitted under the new senior credit agreement. We are required to repay the new term loan portion of the new senior secured credit facilities in quarterly principal installments of 0.25% of the principal amount, with the balance payable at maturity.

 

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The new senior credit agreement contains a number of covenants that, among other things, restrict, subject to certain exceptions, our ability to: (i) incur additional indebtedness; (ii) create liens on assets; (iii) engage in mergers or consolidations; (iv) sell assets; (v) pay dividends and distributions or repurchase our capital stock; (vi) make capital expenditures; (vii) make investments, loans or advances; (viii) repay certain indebtedness; (ix) engage in certain transactions with affiliates; (x) enter into sale and leaseback transactions; (xi) amend material agreements governing certain of our indebtedness; (xii) change our lines of business; (xiii) make certain acquisitions; (xiv) change the status of NMH Holdings as a passive holding company; and (xv) limitations on the letter of credit cash collateral account. If we withdraw any of the $50.0 million from the cash collateral account supporting the issuance of letters of credit, we must use the cash to either prepay the new term loan facility or to secure any other obligations under the new senior secured credit facilities in a manner reasonably satisfactory to the administrative agent. The new senior credit agreement contains customary affirmative covenants and events of default. The new senior credit agreement also requires us to maintain certain financial covenants, as described under “—Covenants” below.
New Senior Notes
On February 9, 2011, we issued $250.0 million in aggregate principal amount of the senior notes. The senior notes were issued pursuant to an indenture, dated as of February 9, 2011, among us, the subsidiary guarantors named therein and Wells Fargo Bank National Association, as trustee. The senior notes were sold at a price equal to 97.737% of their face value. The senior notes mature on February 15, 2018 and bear interest at a rate of 12.5% per annum, payable semi-annually on February 15 and August 15 of each year, beginning on August 15, 2011. The senior notes are our unsecured obligations and are fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by certain of our existing subsidiaries.
We may redeem the senior notes at our option, in whole or part, at any time prior to February 15, 2014, at a price equal to 100% of the principal amount of the senior notes redeemed plus accrued and unpaid interest to the redemption date and plus an applicable premium. We may redeem the senior notes, in whole or in part, on or after February 15, 2014, at the redemption prices set forth in the indenture plus accrued and unpaid interest to the redemption date. At any time on or before February 15, 2014, we may choose to redeem up to 35% of the aggregate principal amount of the senior notes at a redemption price equal to 112.5% of the principal amount thereof, plus accrued and unpaid interest to the redemption date, with the net proceeds of one or more equity offerings, so long as at least 65% of the original aggregate principal amount of the senior notes remain outstanding after each such redemption.
The indenture contains covenants that limit our and most of our subsidiaries’ ability to, among other things: (i) pay dividends, redeem stock or make other distributions or investments; (ii) incur additional debt or issue certain preferred stock; (iii) create liens on assets; (iv) transfer or sell assets; (v) engage in certain transactions with affiliates; (vi) create restrictions on dividends or other payments by our restricted subsidiaries; and (vii) merge, consolidate or sell substantially all of our assets.
Covenants
The new senior credit agreement contains financial covenants. We are required to maintain at the end of each fiscal quarter, commencing with the quarter ending September 30, 2011, a consolidated leverage ratio of not more than 7.25 to 1.00. This consolidated leverage ratio will step down over time, starting with the quarter ending December 31, 2012. The consolidated 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. We are also required to maintain at the end of each fiscal quarter, commencing with the quarter ending September 30, 2011, a consolidated interest coverage ratio of at least 1.30 to 1.00. This interest coverage ratio will step up over time, starting with the quarter ending March 31, 2012. 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.

 

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Contractual Commitments Summary
The following table summarizes our contractual obligations and commitments as of December 31, 2010:
                                         
            Less Than                     More Than  
    Total     1 Year     1-3 Years     3-5 Years     5 Years  
(In thousands)                  
Long-term debt obligations(1)(2)
  $ 503,550     $ 3,667     $ 319,883     $ 180,000     $  
Operating lease obligations(3)
    144,638       39,558       52,636       30,594       21,850  
Capital lease obligations
    1,662       65       131       158       1,308  
Contingent consideration
    3,433       3,433                    
Standby letters of credit
    35,899       35,899                    
 
                             
Total obligations and commitments(4)
  $ 689,182       82,622       372,650       210,752       23,158  
 
                             
 
     
(1)  
Does not include interest on long-term debt or the $223.3 million of senior floating rate toggle notes due 2014, net of discount, issued by NMH Holdings. Approximately $13.5 million of the outstanding senior floating rate toggle notes were held by us.
 
(2)  
Does not reflect long-term debt incurred or long-term debt repaid in connection with the refinancing transactions on February 9, 2011. On February 9, 2011, we (i) entered into a new senior credit agreement for new senior secured credit facilities, consisting of a $530.0 million term loan and a $75.0 million revolver, of which $900,000 was drawn at closing, and issued $250.0 million in aggregate principal amount of 12.50% senior notes due 2018, and (ii) repaid all borrowings under our old senior secured credit facilities and our mortgage facility and purchased $171.9 million of our senior subordinated notes.
 
(3)  
Includes the fixed rent payable under the leases and does not include additional amounts, such as taxes, that may be payable under the leases.
 
(4)  
The table above does not include $4.9 million of unrecognized tax benefits for uncertain tax positions and $1.9 million of associated accrued interest and penalties. Due to the high degree of uncertainty regarding the timing of potential future cash flows, we are unable to reasonably estimate the amount and period in which these liabilities might be paid.
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 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.
As of December 31, 2010, there has been no material change in our accounting policies or the underlying assumptions or methodology used to fairly present our financial position, results of operations and cash flows for the periods covered by this report. In addition, no triggering events have come to our attention pursuant to our review of goodwill and long-lived assets that would indicate impairment of these assets as of December 31, 2010.
For further discussion of our critical accounting policies see management’s discussion and analysis of financial condition and results of operations contained in our Form 10-K for the year ended September 30, 2010.
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”).

 

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These statements relate to future events or our future financial performance, and include statements about our expectations for future periods with respect to demand for our services, the political climate and budgetary environment, our expansion efforts and the impact of our recent acquisitions, our plans for divestitures, investments in our infrastructure and business process improvements, our margins, our liquidity and our financing plans. 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;
 
   
changes in reimbursement rates, policies or payment practices by our payors;
 
   
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;
 
   
changes in interest rates;
 
   
an increase in the number and nature of pending legal proceedings and the outcomes of those proceedings;
 
   
an increase in our self-insured retentions and changes in the insurance market for professional and general liability, workers’ compensation and automobile liability and our claims history that affect our ability to obtain coverage at reasonable rates;
 
   
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;
 
   
our ability to establish and maintain relationships with government agencies and advocacy groups;
 
   
increased or more effective competition;
 
   
successful integration of acquired businesses; and
 
   
the potential for conflict between the interests of our majority equity holder and those of our debt holders.
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.
The Company was previously a party to interest rate swap agreements in order to reduce the interest rate exposure on the term B loan but these agreements have now expired. The Company is currently considering its options for managing its interest rates.

 

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As of December 31, 2010 we had $323.6 million of variable rate debt outstanding. The variable rate debt outstanding related to the term B loan, which had an interest rate based on LIBOR plus 2.00% or Prime plus 1.00%, the senior revolver, which had an interest rate based on LIBOR plus 2.00% or Prime plus 1.00%, subject to reduction depending on our leverage ratio, and the mortgage facility, which had 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 for the three months ended December 31, 2010 by $3.2 million. As of February 9, 2011, we had $530.9 million of variable rate debt outstanding.
Item 4.  
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, the President and the 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 December 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 effective as of December 31, 2010.
(b) Changes in Internal Control over Financial Reporting
During the quarter ended December 31, 2010, we continued refinement of our new billing and accounts receivable process and related 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 further optimize and refine the billing and accounts receivable process and related system, we will review the related controls and may take additional steps to ensure that they remain effective and are integrated appropriately.
Except for the continuing optimization of our billing and accounts receivable process and related system, 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 health and human services business and, therefore, we have been and continue to be subject to substantial 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 and state health insurance program through which state expenditures are matched by federal funds typically ranging from 50% to approximately 76% 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. For the period from October 1, 2008 through June 30, 2011, under the American Recovery and Reinvestment Act of 2009, the federal government had temporarily increased its share of the costs. As a result, it is providing state governments with more than $100 billion in federal Medicaid funding during this period to help address state budget gaps caused by a steep decline in tax collections and significantly increased Medicaid enrollment, among other factors, during the recent recessionary period. Budgetary pressures, particularly during the recent recessionary period 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. Furthermore, the termination of enhanced federal Medicaid funding, scheduled for July 1, 2011, is expected to occur well before state revenues are projected to return to pre-recessionary levels and is expected to significantly increase the budgetary challenges confronting state governments for fiscal year 2012, which begins July 1, 2011 in most states. In addition, there is risk that previously appropriated funds could be reduced through subsequent legislation. The Patient Protection and Affordable Care Act of 2010 mandates certain uses for Medicaid funds, which could have the effect of diverting those funds from the services we provide. Many states in which we operate have been experiencing unprecedented budgetary deficits and constraints and have implemented or are considering initiating service reductions, rate freezes and/or rate reductions, including states such as Minnesota, California, Indiana 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. Eleven 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 December 31, 2010, we had total indebtedness of $505.2 million, no borrowings under our senior revolver and $109.1 million of availability under our senior revolver. The old senior secured credit facilities also included a $20.0 million synthetic letter of credit facility, all of which had been fully utilized. The availability under our senior revolver was reduced from $125.0 million as $15.9 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. On February 9, 2011, we completed refinancing transactions, as a result of which we replaced our old senior secured credit facilities and senior subordinated notes with (i) new senior secured credit facilities consisting of a $530.0 million term loan facility, of which $50.0 million was deposited in a cash collateral account in support of issuance of letters of credit, and a $75.0 million new senior revolver, and (ii) $250.0 million in aggregate principal amount of senior notes.

 

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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 acquisitions and capital expenditures;
 
   
the debt service requirements of our indebtedness could make it more difficult for us to satisfy our indebtedness and contractual and commercial commitments;
 
   
interest rates on our variable interest rate borrowings under the new senior secured credit facilities may increase;
 
   
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;
 
   
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; and
 
   
it may prevent us from raising the funds necessary to repurchase senior subordinated notes tendered to us if there is a change of control, which would constitute a default under the new senior credit agreement governing our new senior secured credit facilities.
Subject to restrictions in the indenture governing our new senior notes and the new senior credit agreement, 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 new senior secured credit facilities are secured by substantially all of the assets of the Company and its subsidiaries.
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 three months ended December 31, 2010, our aggregate rental payments for these leases, including taxes and operating expenses, was $11.8 million. These obligations could further increase the risks described above.
Current credit and economic conditions could have a material adverse effect on our cash flows, liquidity and financial condition.
Due to the general 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 beginning in January 2011. Given the composition of our workforce, these mandates could be material to our costs, and we are studying the potential impact of these mandates.

 

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Although our employees are generally not unionized, we recently acquired a business in New Jersey with forty-nine employees who are represented by a labor union. Future unionization activities could result in an increase of our labor and other costs. The President and the National Labor Relations Board may take regulatory and other action that could result in increased unionization activities and make it easier for employees to join unions. 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 new senior credit agreement governing the new senior secured credit facilities and the indenture governing the senior 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.
The new senior credit agreement governing the new 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 new 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, litigation and governmental investigations.
We are in the health and human services business and, therefore, we have been and continue to be subject to substantial 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, and our claims for professional and general liability have increased sharply in recent years. 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.

 

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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.
We also are subject to potential lawsuits under the False Claims Act and 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. If we are found to have violated the False Claims Act, we could be excluded from participation in Medicaid and other federal healthcare programs. The Patient Protection and Affordable Care Act provides a mandate for more vigorous and widespread enforcement activity.
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.
Our financial results could be adversely affected if claims against us are successful, to the extent we must make payments under our self-insured retentions, or if such claims are not covered by our applicable insurance or if the costs of our insurance coverage increase.
We have been and continue to be subject to substantial claims against our professional and general liability and automobile liability insurance. Any claims, if successful, could result in substantial damage awards which might require us to make payments under our self-insured retentions. We have historically self-insured amounts of up to $1.0 million per claim and up to $2.0 million in the aggregate, but as of October 1, 2010, we are self-insured for $2.0 million per claim and $8.0 million in the aggregate, and for $500,000 per claim in excess of the aggregate. An award may exceed the limits of any applicable insurance coverage, and awards for punitive damages may be excluded from our insurance policies either contractually or by operation of state law. In addition, our insurance does not cover all potential liabilities including, for example, those arising from governmental fines and penalties. As a result, we may become responsible for substantial damage awards that are uninsured.
Insurance against professional and general liability and automobile liability can be expensive. Our insurance premiums have increased and may increase in the near future. Insurance rates vary from state to state, by type and by other factors. The rising costs of insurance premiums, as well as successful claims against us, could have a material adverse effect on our financial position and results of operations.
It is also possible that our liability and other insurance coverage will not continue to be available at acceptable costs or on favorable terms.
If payments for claims exceed actuarially determined estimates, are not covered by insurance, or our insurers fail to meet their obligations, our results of operations and financial position could be adversely affected.
Because a substantial portion of 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 and borrowings under the senior secured term loan facility, bears interest at rates that fluctuate with changes in certain short-term prevailing interest rates. If interest rates increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same.
As of December 31, 2010, we had $323.6 million of floating rate debt outstanding. A 1% increase in the interest rate on our floating rate debt would have increased cash interest expense of the floating rate debt for the three months ended December 31, 2010 by $3.2 million. As of February 9, 2011, we had $530.9 million of floating rate debt outstanding. If interest rates increase dramatically, the Company and its subsidiaries could be unable to service their debt.

 

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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. 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. If we fail to comply with federal and state documentation, coding and billing rules, we could be subject to criminal and/or civil penalties, loss of licenses and exclusion from the Medicaid programs, which could harm us. In billing for our services to third-party payors, we must follow complex documentation, coding and billing rules. These rules are based on federal and state laws, rules and regulations, various government pronouncements, and on industry practice. Failure to follow these rules could result in potential criminal or civil liability under the False Claims Act, under which extensive financial penalties can be imposed. It could further result in criminal liability under various federal and state criminal statutes. We annually submit a large volume of claims for Medicaid and other payments and there can be no assurance that there have not been errors. The rules are frequently vague and confusing and we cannot assure that governmental investigators, private insurers or private whistleblowers will not challenge our practices. Such a challenge could result in a material adverse effect on our business.
If any of the state and local government payors determine 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 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 and are 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. Failure to comply with laws and regulations could have a material adverse effect on our business.

 

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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.
   
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 or litigation 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 and other 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 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.

 

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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.
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, or those of our employees, 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”) and other federal and state data privacy and security laws, which require 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.

 

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The federal anti-kickback law and non-self referral statute, and similar state statutes, prohibit kickbacks, rebates and any other form of remuneration in return for referrals. Any remuneration, direct or indirect, offered, paid, solicited, or received, in return for referrals of patients or business for which payment may be made in whole or in part under Medicaid could be considered a violation of law. The language of the anti-kickback law also prohibits payments made to anyone to induce them to recommend purchasing, leasing, or ordering any goods, facility, service, or item for which payment may be made in whole or in part by Medicaid. Criminal penalties under the anti-kickback law include fines up to $25,000, imprisonment for up to 5 years, or both. In addition, acts constituting a violation of the anti-kickback law may also lead to civil penalties, such as fines, assessments and exclusion from participation in the Medicaid programs.
CMS employs Medicaid Integrity Contractors (“MICs”) to perform post-payment audits of Medicaid claims and identify overpayments. Throughout 2011, we expect MIC audits will continue to expand. In addition to MICs, several other contractors, including the state Medicaid agencies, have increased their review activities.
Should we be found out of compliance with any of these laws, regulations or programs, depending on the nature of the findings, our business, our financial position and our results of operations could be materially adversely impacted.
If a federal or state agency asserts a different position or enacts new laws or regulations regarding illegal payments under Medicaid or other governmental programs, we may be subject to civil and criminal penalties, experience a significant reduction in our revenue or be excluded from participation in Medicaid or other governmental programs.
Any change in interpretations or enforcement of existing or new laws and regulations could subject our current business practices to allegations of impropriety or illegality, or could require us to make changes in our homes, equipment, personnel, services, pricing or capital expenditure programs, which could increase our operating expenses and have a material adverse effect on our operations or reduce the demand for or profitability of our services.
We have identified material weaknesses in our internal control over financial reporting in prior periods.
As reported in 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 relating to our revenue and accounts receivable balances as of September 30, 2009, and management concluded that as of that date, our internal control over financial reporting was not effective and, as a result, our disclosure controls and procedures were not effective. We also reported material weaknesses as of September 30, 2008, including a material weakness in controls to verify the existence of our fixed asset balances. As a result of 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 to remediate our identified material weaknesses and continue to improve our internal controls, the decentralized nature of our operations and the manual nature of many of our controls increases our risk of control deficiencies.
We did not experience similar material weaknesses in connection with our audit of fiscal 2010. No evaluation can provide complete assurance that our internal controls will detect or uncover all failures of persons within our company to disclose material information otherwise required to be reported. The effectiveness of our controls and procedures could also be limited by simple errors or faulty judgments. We may in the future identify material weaknesses or significant deficiencies in connection with the continuing implementation of our billing and accounts receivable system and the consolidation of our cash disbursement function at one centralized location. As we introduce new processes and people into our accounting systems, our risk of controls deficiencies and weaknesses may temporarily increase. In addition, if we continue to make acquisitions, as we expect to, the challenges involved in implementing appropriate internal controls will increase and will require that we continue to improve our internal controls. Any future material weaknesses in internal control over financial reporting could result in material misstatements in our financial statements. Moreover, any future disclosures of additional material weaknesses, or errors as a result of those weaknesses, could result in a negative reaction in the financial markets if there is a loss of confidence in the reliability of our financial reporting.
Management continues to devote significant time and attention to improving our internal controls, and we will continue to incur costs associated with implementing appropriate processes, which could include fees for additional audit and consulting services, 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.

 

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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.
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 three months ended December 31, 2010, 15% 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. A rate cut of 2.6% took effect in Minnesota on July 1, 2009. 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 key employees, 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 and successfully optimize our cost structure.
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. We also are continuing to take actions to optimize our cost structure, including most recently centralizing certain functions and implementing a review of our field administrative functions. To the extent these optimization efforts and any related reductions in force disrupt our operations, there could be an adverse effect on our financial results. In addition, our cost structure optimization efforts may not achieve the cost savings we expect within the anticipated time frame, or at all. Our inability to manage growth and implement cost structure optimization effectively could have a material adverse effect on our results of operations, financial position and cash flows.
Our information systems are critical to our business and a failure of those systems could materially harm us.
We depend on our ability to store, retrieve, process and manage a significant amount of information, and to provide our operations with efficient and effective accounting, census, incident reporting and scheduling systems. Our information systems require maintenance and upgrading to meet our needs, which could significantly increase our administrative expenses.
Furthermore, any system failure that causes an interruption in service or availability of our critical systems could adversely affect operations or delay the collection of revenues. Even though we have implemented network security measures, our servers are vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering. The occurrence of any of these events could result in interruptions, delays, the loss or corruption of data, or cessations in the availability of systems, all of which could have a material adverse effect on our financial position and results of operations and harm our business reputation.
The performance of our information technology and systems is critical to our business operations. Our information systems are essential to a number of critical areas of our operations, including:
   
accounting and financial reporting;
 
   
billing and collecting accounts;
 
   
coding and compliance;
 
   
clinical systems, including census and incident reporting;
 
   
records and document storage; and
 
   
monitoring quality of care and collecting data on quality and compliance measures.
Our financial results may suffer if we have to write-off goodwill or other intangible assets.
A portion of our total assets consists of goodwill and other intangible assets. Goodwill and other intangible assets, net of accumulated amortization, accounted for 65.2% and 65.7% of the total assets on our balance sheet as of December 31, 2010 and September 30, 2010, respectively. We may not realize the value of our goodwill or other intangible assets and we expect to engage in additional transactions that will result in our recognition of additional goodwill or other intangible assets. We evaluate on a regular basis whether events and circumstances have occurred that indicate that all or a portion of the carrying amount of goodwill or other intangible assets may no longer be recoverable, and is therefore impaired. Under current accounting rules, any determination that impairment has occurred would require us to write-off the impaired portion of our goodwill or the unamortized portion of our intangible assets, resulting in a charge to our earnings. Such a write-off could have a material adverse effect on our financial condition and results of operations.

 

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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 pay overtime or hire replacement staff and Mentors for workers who drop out of the workforce. 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 material 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. 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 or NMH Investment were sold during the three months ended December 31, 2010.
Repurchases of Equity Securities
No equity securities of the Company were repurchased during the three months ended December 31, 2010.
The following table sets forth information in connection with repurchases made by NMH Investment of its common equity units during the three months ended December 31, 2010:
                                 
                            (d) Maximum  
                            Number (or  
                    (c) Total Number     Approximate Dollar  
                    of Units Purchased     Value) of Shares (or  
    (a) Class and             as Part of Publicly     Units) that May Yet  
    Total Number of     (b) Average Price     Announced Plans     be Purchased Under  
    Units Purchased     Paid per Unit     or Programs     the Plans or Programs  
Month #1 (October 1, 2010 through October 31, 2010)
  481.25 B Units   $ 0.05             N/A  
 
  505.00 C Units   $ 0.03             N/A  
 
  535.00 D Units   $ 0.01             N/A  
Month #2 (November 1, 2010 through November 30, 2010)
  1,443.75 B Units   $ 0.05             N/A  
 
  1,515.00 C Units   $ 0.03             N/A  
 
  1,605.00 D Units   $ 0.01             N/A  
Month #3 (December 1, 2010 through December 31, 2010)
  40,000.00 A Units   $ 10.00             N/A  
 
  6,623.40 B Units   $ 0.05             N/A  
 
  6,756.90 C Units   $ 0.03             N/A  
 
  20,274.33 D Units   $ 0.01             N/A  
The Company did not repurchase any of its common stock as part of an equity repurchase program during the three months ended December 31, 2010. NMH Investment purchased all of the units listed in the table from three of its employees upon their departures.

 

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Item 3.  
Defaults Upon Senior Securities.
None.
Item 4.  
(Removed and Reserved).
Item 5.  
Other Information.
On February 11, 2011, Juliette E. Fay entered into a letter agreement (the “letter agreement”) in which she tendered her resignation to National Mentor Holdings, Inc. (the “Company”), effective March 31, 2011. Ms. Fay is our Executive Vice President and Chief Development Officer. Upon her departure, Ms. Fay will be entitled to the benefits provided upon a resignation for “Good Reason” under her Amended and Restated Severance Agreement dated as of December 31, 2008, the form of which is filed as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended December 31, 2008. In addition to those benefits, which are summarized in the Company’s most recent Annual Report on Form 10-K, pursuant to the letter agreement, she will be entitled to receive an additional payment of $50,000 and reimbursement of attorney’s fees up to $15,000, and will retain her Company-provided computer, printer, cellphone and blackberry devices.
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.
 
 
February 14, 2011   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
           
 
  10.1 *   Letter Agreement between National Mentor Holdings, Inc. and Hugh R. Jones III dated November 16, 2010  
Incorporated by reference to Exhibit 10.1 of National Mentor Holdings, Inc.’s Current Report on Form 8-K filed on November 22, 2010.
           
 
  10.2 *   Letter Agreement between National Mentor Holdings, Inc. and Juliette E. Fay dated February 11, 2011  
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
 
     
*  
Management contract or compensatory plan or arrangement.

 

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