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Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x

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

For the quarterly period ended December 31, 2011

OR

 

¨

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

For the transition period from                     to                    

Commission file number: 333-129179

 

 

NATIONAL MENTOR HOLDINGS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   31-1757086

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

313 Congress Street, 6th Floor

Boston, Massachusetts 02210

  (617) 790-4800

(Address of principal executive offices,

including zip code)

 

(Registrant’s telephone number,

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   ¨    No  x

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   x    No  ¨

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

 

¨

  

Accelerated filer

 

¨

Non-accelerated filer

 

x  (Do not check if smaller reporting company)

  

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  ¨    No   x

As of February 14, 2012, there were 100 shares outstanding of the registrant’s common stock, $.01 par value.

 

 

 


Table of Contents

Index

National Mentor Holdings, Inc.

 

     Page  

PART I. FINANCIAL INFORMATION

     3   

Item 1. Financial Statements

     3   

Condensed Consolidated Balance Sheets as of December 31, 2011 and September 30, 2011

     3   

Condensed Consolidated Statements of Operations for the three months ended December 31, 2011 and 2010

     4   

Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2011 and 2010

     5   

Notes to Condensed Consolidated Financial Statements

     6   

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     15   

Item 3. Quantitative and Qualitative Disclosures about Market Risk

     24   

Item 4. Controls and Procedures

     25   

PART II. OTHER INFORMATION

     25   

Item 1. Legal Proceedings

     25   

Item 1A. Risk Factors

     26   

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

     36   

Item 3. Defaults Upon Senior Securities

     36   

Item 4. Mine Safety Disclosures

     36   

Item 5. Other Information

     36   

Item 6. Exhibits

     36   

Signatures

     37   

 

2


Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements.

National Mentor Holdings, Inc.

Condensed Consolidated Balance Sheets

(In thousands)

 

September 30, September 30,
       (Unaudited)  
        December 31,
2011
     September 30,
2011
 

ASSETS

       

Current assets:

       

Cash and cash equivalents

     $ —         $ 263   

Restricted cash

       825         936   

Accounts receivable, net

       152,374         134,071   

Deferred tax assets, net

       20,835         20,956   

Prepaid expenses and other current assets

       11,558         9,969   
    

 

 

    

 

 

 

Total current assets

       185,592         166,195   

Property and equipment, net

       148,466         146,256   

Intangible assets, net

       390,575         397,514   

Goodwill

       231,953         231,015   

Restricted cash

       50,000         50,000   

Other assets

       56,948         19,870   
    

 

 

    

 

 

 

Total assets

     $ 1,063,534       $ 1,010,850   
    

 

 

    

 

 

 

LIABILITIES AND SHAREHOLDER’S EQUITY

       

Current liabilities:

       

Accounts payable

     $ 25,613       $ 27,059   

Accrued payroll and related costs

       74,268         74,968   

Other accrued liabilities

       56,302         46,528   

Obligations under capital lease, current

       316         312   

Current portion of long-term debt

       17,300         5,300   
    

 

 

    

 

 

 

Total current liabilities

       173,799         154,167   

Other long-term liabilities

       54,051         15,536   

Deferred tax liabilities, net

       108,533         111,066   

Obligations under capital lease, less current portion

       8,852         6,462   

Long-term debt, less current portion

       754,157         754,742   

Commitments and contingencies

       

SHAREHOLDER’S EQUITY

       

Common stock

       —           —     

Additional paid-in capital

       33,263         33,098   

Accumulated other comprehensive loss

       (3,838      (4,017

Accumulated deficit

       (65,283      (60,204
    

 

 

    

 

 

 

Total shareholder’s equity

       (35,858      (31,123
    

 

 

    

 

 

 

Total liabilities and shareholder’s equity

     $ 1,063,534       $ 1,010,850   
    

 

 

    

 

 

 

See accompanying notes.

 

3


Table of Contents

National Mentor Holdings, Inc.

Condensed Consolidated Statements of Operations

(In thousands)

(Unaudited)

 

September 30, September 30,
       Three Months Ended
December 31,
 
       2011      2010  

Net revenue

     $ 274,433       $ 264,473   

Cost of revenue (exclusive of depreciation expense shown below)

       213,747         204,218   

Operating expenses:

       

General and administrative

       33,290         34,340   

Depreciation and amortization

       14,901         14,711   
    

 

 

    

 

 

 

Total operating expenses

       48,191         49,051   
    

 

 

    

 

 

 

Income from operations

       12,495         11,204   

Other income (expense):

       

Management fee of related party

       (315      (345

Other income, net

       284         228   

Interest income

       4         5   

Interest income from related party

       —           494   

Interest expense

       (19,787      (8,146
    

 

 

    

 

 

 

(Loss) income from continuing operations before income taxes

       (7,319      3,440   

(Benefit) provision for income taxes

       (2,304      1,471   
    

 

 

    

 

 

 

(Loss) income from continuing operations

       (5,015      1,969   

Loss from discontinued operations, net of tax

       (64      (203
    

 

 

    

 

 

 

Net (loss) income

     $ (5,079    $ 1,766   
    

 

 

    

 

 

 

See accompanying notes.

 

4


Table of Contents

National Mentor Holdings, Inc.

Condensed Consolidated Statements of Cash Flows

 

September 30, September 30,
       Three Months Ended
December 31,
 
       2011      2010  
      

(unaudited)

(Amounts in thousands)

 

Operating activities

       

Net (loss) income

     $ (5,079    $ 1,766   

Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities:

       

Accounts receivable allowances

       2,952         2,747   

Depreciation and amortization of property and equipment

       5,776         5,772   

Amortization of other intangible assets

       9,129         9,239   

Amortization of original issue discount and initial purchasers discount

       741         —     

Amortization and write-off of financing costs

       594         792   

Accretion of investment in related party debt securities

       —           (243

Stock-based compensation

       165         —     

Deferred income taxes

       (2,534      (1,342

Gain on disposal of assets

       (22      (45

Change in the fair value of contingent consideration

       —           222   

Non-cash impairment charge

       (18      (22

Non-cash interest income from related party

       —           (251

Changes in operating assets and liabilities:

       

Accounts receivable

       (21,255      (1,303

Other assets

       (2,024      2,173   

Accounts payable

       (750      (8,399

Accrued payroll and related costs

       (700      (1,069

Other accrued liabilities

       10,110         9,138   

Other long-term liabilities

       1,295         819   
    

 

 

    

 

 

 

Net cash (used in) provided by operating activities

       (1,620      19,994   

Investing activities

       

Cash paid for acquisitions, net of cash received

       (3,150      (2,933

Purchases of property and equipment

       (6,262      (3,958

Changes in restricted cash

       111         173   

Proceeds from sale of assets

       79         209   
    

 

 

    

 

 

 

Net cash used in investing activities

       (9,222      (6,509

Financing activities

       

Repayments of long-term debt

       (1,325      (916

Proceeds from borrowings under senior revolver

       107,000         —     

Repayments of borrowings under senior revolver

       (95,000      —     

Repayments of capital lease obligations

       (76      (55

Cash paid for contingent consideration

       —           (3,313

Dividend to Parent

       —           (511

Payments of financing costs

       (20      (602
    

 

 

    

 

 

 

Net cash provided by (used in) financing activities

       10,579         (5,397

Net (decrease) increase in cash and cash equivalents

       (263      8,088   

Cash and cash equivalents at beginning of period

       263         26,448   
    

 

 

    

 

 

 

Cash and cash equivalents at end of period

     $ —         $ 34,536   
    

 

 

    

 

 

 

Supplemental disclosure of cash flow information

       

Cash paid for interest

     $ 10,379       $ 2,260   

Cash paid for income taxes

     $ 72       $ 441   

Supplemental disclosure of non-cash investing activities:

       

Accrued property, plant and equipment

     $ 783       $ —     

Supplemental disclosure of non-cash financing activities:

       

Capital lease obligation incurred to acquire assets

     $ 2,434       $ —     

See accompanying notes.

 

5


Table of Contents

National Mentor Holdings, Inc.

Notes to Condensed Consolidated Financial Statements

December 31, 2011

(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’s operations have grown to 33 states. The Company provides residential services to approximately 11,000 clients, some of whom also receive periodic services. Approximately 16,000 clients receive periodic services from the Company.

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, 2011, 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, 2011 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

Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS — In May 2011, the FASB issued Accounting Standards Update No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS (“ASU 2011-04”). Under ASU 2011-04, the valuation premise of highest and best use is only relevant when measuring the fair value of nonfinancial assets. Additionally, ASU 2011-04 includes enhanced disclosure requirements for fair value measurements. ASU 2011-04 is effective for the Company beginning in the second quarter of fiscal 2012. The Company is evaluating the impact of this guidance on its financial statements.

Presentation of Comprehensive Income — In June 2011, the FASB issued Accounting Standards Update No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income (“ASU 2011-05”). ASU 2011-05 eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. The final standard requires entities to present net income and other comprehensive income in either a single continuous statement or in two separate, but consecutive, statements of net income and other comprehensive income. ASU 2011-05 is effective for the Company beginning in the first quarter of fiscal 2013. The Company does not expect this to have a material impact to its financial statements.

 

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Table of Contents

In December 2011, the FASB issued ASU No. 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 (“ASU 2011-12”), to defer the changes in ASU 2011-05 that relate to the presentation of reclassification adjustments to other comprehensive income. These amendments are being delayed to allow the FASB time to re-deliberate whether to present the effects of reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income on the face of the financial statements for all periods presented . While the FASB is considering the operational concerns about the presentation requirements for reclassification adjustments and the needs of financial statement users for additional information about reclassification adjustments, the Company is required to continue reporting reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before ASU 2011-05.

Intangibles — Goodwill and Other — In September 2011, the FASB issued Accounting Standards Update No. 2011-08, Intangibles — Goodwill and Other (Topic 350): Testing Goodwill for Impairment (“ASU 2011-08”). Under ASU 2011-08, an entity has the option to first assess qualitative factors to determine whether further impairment testing is necessary. Additionally, an entity has the option to bypass the qualitative assessment for any reporting unit in any period and proceed directly to performing the first step of the impairment test, and the perform the qualitative assessment in any subsequent period. ASU 2011-08 is effective for the Company beginning fiscal 2013. The Company is evaluating the impact of this guidance on its financial statements.

Balance Sheet: Disclosures about Offsetting Assets and Liabilities —In December 2011, the FASB issued Accounting Standards Update 2011-11, Balance Sheet: Disclosures about Offsetting Assets and Liabilities. The differences in the requirements for offsetting assets and liabilities in the presentation of financial statements prepared in accordance with U.S. GAAP and financial statements prepared in accordance with International Financial Reporting Standards (IFRS) makes the comparability of those statements difficult. The objective of this update is to facilitate comparison between those financial statements, specifically within the scope instruments and transactions eligible for offset in the form of derivatives, sale and repurchase agreements and reverse sale and repurchase agreements, and securities borrowing and securities lending arrangements. This update is effective for annual reporting periods beginning on or after January 1, 2013 and interim periods within that fiscal year. The Company is evaluating the impact of this guidance on its financial statements.

Recently Adopted

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 was effective for the Company beginning the first quarter of the fiscal year ending September 30, 2012 (“fiscal 2012”) and resulted in an increase of $37.2 million in Other assets and a corresponding increase in Other long-term liabilities on the Company’s December 31, 2011 balance sheet. This adoption did not have an impact on the Company’s results of operations or cash flows.

Disclosure of Supplementary Pro Forma Information for Business Combinations — In December 2010, the FASB issued Accounting Standards Update 2010-29, Business Combinations (Topic 805), Disclosure of Supplementary Pro Forma Information for Business Combinations (“ASU 2010-29”). ASU 2010-29 requires a public entity to disclose pro forma revenue and earnings of the combined entity for the current reporting period as though the acquisition date for all business combinations that occurred during the fiscal year had been as of the beginning of the annual reporting period or the beginning of the comparable prior annual reporting period if showing comparative financial statements. ASU 2010-29 was effective prospectively for the Company for business combinations for which the acquisition date is on or after October 1, 2011.

3. Comprehensive (Loss) Income

The components of comprehensive (loss) income and related tax effects are as follows:

 

September 30, September 30,
       Three Months Ended
December 31,
 
       2011      2010  
       (in thousands)  

Net (loss) income

     $ (5,079    $ 1,766   

Changes in unrealized gain on derivatives net of taxes of $121

       179         —     

Changes in unrealized gain on available-for-sale debt securities net of taxes of $137

       —           207   
    

 

 

    

 

 

 

Comprehensive (loss) income

     $ (4,900    $ 1,973   
    

 

 

    

 

 

 

 

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Table of Contents

4. Long-Term Debt

The Company’s long-term debt consists of the following:

 

September 30, September 30,

(in thousands)

     December 31,
2011
     September 30,
2011
 

Term loan, principal and interest due in quarterly installments through February 9, 2017

     $ 526,025       $ 527,350   

Original issue discount on term loan, net of accumulated amortization

       (6,744      (7,081

Senior notes, due February 15, 2018; semi-annual cash interest payments due each February 15th and August 15th (interest rate of 12.50%)

       250,000         250,000   

Original issue discount and initial purchase discount on senior notes, net of accumulated amortization

       (9,824      (10,227

Senior revolver, due February 9, 2016; quarterly cash interest payments at a variable interest rate

       12,000         —     
    

 

 

    

 

 

 
       771,457         760,042   

Less current portion

       17,300         5,300   
    

 

 

    

 

 

 

Long-term debt

     $ 754,157       $ 754,742   
    

 

 

    

 

 

 

Senior Secured Credit Facilities

On February 9, 2011, the Company completed refinancing transactions (the “February 2011 Refinancing”) and entered into new senior secured credit facilities, consisting of a (i) six-year $530.0 million term loan facility (the “term loan”), 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 (ii) $75.0 million five-year senior secured revolving credit facility (the “senior revolver”). The Company refers to these facilities as the “senior secured credit facilities”.

Term loan

The $530.0 million term loan was issued at a price equal to 98.5% of its face value and amortizes one percent per year, paid quarterly, with the remaining balance payable at maturity. The senior credit agreement also includes a provision for the prepayment of a portion of the outstanding term loan amounts beginning in fiscal 2011 equal to an amount ranging from 0 to 50% of a calculated amount, depending on the Company’s leverage ratio, if the Company generates certain levels of cash flow. The Company was not required to make such a prepayment of its term loan during fiscal 2011. The variable interest rate on the term loan is equal to (i) a rate equal to the greater of (a) the prime rate, (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%, at the Company’s option. At December 31, 2011, the variable interest rate on the term loan was 7.0%.

Senior revolver

During three months ended December 31 2011, the Company drew $107.0 million under the senior revolver and repaid $95.0 million during the period. At December 31, 2011, the Company had $12.0 million of outstanding borrowings under the senior revolver and $63.0 million of availability under the senior revolver and $35.8 million of standby letters of credit issued under the institutional letter of credit facility primarily related to the Company’s workers’ compensation insurance coverage. Letters of credit can be issued under the Company’s institutional letter of credit facility up to the $50.0 million limit and letters of credit in excess of that amount reduce availability under the Company’s senior revolver. The interest rates for any borrowings under the senior revolver are the same as the term loan.

The senior revolver includes borrowing capacity available for borrowings on same-day notice, referred to as the “swingline loans.” The outstanding borrowings at December 31, 2011 were borrowed under the swingline, which have maturities less than one year, and are reflected under Current portion of long-term debt on the Company’s balance sheet.

Senior Notes

In connection with the February 2011 Refinancing, the Company issued $250.0 million of the senior notes at a price equal to 97.737% of their face value, for net proceeds of $244.3 million. The net proceeds were reduced by an initial purchasers’ discount of $5.6 million. The senior notes are the Company’s unsecured obligations and are guaranteed by certain of the Company’s existing subsidiaries.

 

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Table of Contents

Covenants

The senior credit agreement and the indenture governing the senior notes contain negative financial and non-financial covenants, including, among other things, limitations on the Company’s ability to incur additional debt, transfer or sell assets, pay dividends, redeem stock or make other distributions or investments, and engage in certain transactions with affiliates. In addition, the senior credit agreement governing the Company’s senior secured credit facilities contains financial covenants that require the Company to maintain a specified consolidated leverage ratio and consolidated interest coverage ratio.

The Company is 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.

Derivatives

The Company entered into an interest rate swap in a notional amount of $400.0 million effective March 31, 2011 and ending September 30, 2014. The Company entered into this interest rate swap to hedge the risk of changes in the floating rate of interest on borrowings under the term loan. Under the terms of the swap, the Company receives from the counterparty a quarterly payment based on a rate equal to the greater of 3-month LIBOR and 1.75% per annum, and the Company makes payments to the counterparty based on a fixed rate of 2.5% per annum, in each case on the notional amount of $400.0 million, settled on a net payment basis. Based on the applicable margin of 5.25% under the Company’s term loan, this swap effectively fixes the Company’s cost of borrowing for $400.0 million of the term loan at 7.8% per annum for the term of the swap.

The Company accounts for the interest rate swap as a cash flow hedge and the effectiveness of the hedge relationship is assessed on a quarterly basis. The fair value of the swap agreement, representing the price that would be paid to transfer the liability in an orderly transaction between market participants, was $6.4 million or $3.8 million after taxes at December 31, 2011. The fair value was recorded in current liabilities (under Other accrued liabilities) and was determined based on pricing models and independent formulas using current assumptions. The entire change in fair market value is recorded in shareholder’s equity, net of tax, on the consolidated balance sheets as accumulated other comprehensive loss.

5. Shareholder’s Equity

Common Stock

The holders of the Company’s common stock are entitled to receive dividends when and as declared by the Company’s Board of Directors. In addition, the holders of common stock are entitled to one vote per share. All of the outstanding shares of common stock are held by Parent.

Dividend to Parent

On February 9, 2011, as part of the refinancing transactions described in note 4, the Company declared a dividend of $219.7 million to Parent, which in turn made a distribution of $219.7 million to its direct parent, NMH Holdings, Inc. (“NMH Holdings”). NMH Holdings used the proceeds of the distribution to (i) repurchase $210.9 million aggregate principal amount of the Senior Floating Rate Toggle Notes due 2014 (the “NMH Holdings notes”) at a premium not including $13.3 million principal amount of NMH Holdings notes the Company held as an investment and that were also repurchased and (ii) pay related fees and expenses.

6. Business Combinations

The operating results of the businesses acquired are 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, 2011, the Company acquired three companies complementary to its business for $3.2 million.

 

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Table of Contents

Families Together. On November 30, 2011, the Company acquired the assets of Families Together, Inc. (“Families Together”) for $3.0 million. Families Together is located in North Carolina and provides intensive in-home services, day treatment, case management, outpatient therapy and similar periodic services to children and their families. As a result of this acquisition, the Company recorded $0.9 million of goodwill in the Human Services segment, which is expected to be deductible for tax purposes. The Company acquired $2.1 million of intangible assets which included $1.0 million of non-compete agreement with a useful life of five years, $0.8 million of agency contracts with a weighted average useful life of eleven years, and $0.3 million of licenses and permits with a weighted average useful life of ten years.

Other Acquisitions. During the three months ended December 31, 2011, the Company acquired selected assets of Zumbro House, Inc., which provides group home services to individuals with developmental disabilities in the Mankato, Minnesota area and Georgia Rehabilitation Institute d/b/a Walton Rehabilitation Health System, a provider of acquired brain injury services, for $0.2 million, $0.1 million of which was allocated to intangible assets.

The following table summarizes the recognized amounts of identifiable assets acquired and liabilities assumed at the date of the acquisition:

 

September 30, September 30, September 30,
       Families        Other           

(in thousands)

     Together        Acquisitions        TOTAL  

Identifiable intangible assets

     $ 2,102         $ 83         $ 2,185   

Property and equipment

       6           21           27   
    

 

 

      

 

 

      

 

 

 

Total identifiable net assets

     $ 2,108         $ 104         $ 2,212   
    

 

 

      

 

 

      

 

 

 

Goodwill

     $ 892         $ 46         $ 938   

7. Goodwill and Intangible Assets

Goodwill

The changes in goodwill for the three months ended December 31, 2011 are as follows:

 

September 30, September 30, September 30,
       Human
Services
       Post Acute
Specialty
Rehabilitation
Services
       Total  
       (In thousands)  

Balance as of September 30, 2011

     $ 167,877         $ 63,138         $ 231,015   

Goodwill acquired through acquisitions

       934           4           938   
    

 

 

      

 

 

      

 

 

 

Balance as of December 31, 2011

     $ 168,811         $ 63,142         $ 231,953   
    

 

 

      

 

 

      

 

 

 

 

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Intangible Assets

Intangible assets consist of the following as of December 31, 2011:

 

September 30, September 30, September 30,

Description

     Gross
Carrying
Value
       Accumulated
Amortization
       Intangible
Assets, Net
 
(in thousands)                           

Agency contracts

     $ 459,883         $ 145,605         $ 314,278   

Non-compete/non-solicit

       3,724           787           2,937   

Relationship with contracted caregivers

       11,118           6,042           5,076   

Trade names

       3,774           1,786           1,988   

Trade names (indefinite life)

       42,400           —             42,400   

Licenses and permits

       43,957           20,632           23,325   

Intellectual property

       904           333           571   
    

 

 

      

 

 

      

 

 

 
     $ 565,760         $ 175,185         $ 390,575   
    

 

 

      

 

 

      

 

 

 

Intangible assets consist of the following as of September 30, 2011:

 

September 30, September 30, September 30,

Description

     Gross
Carrying
Value
       Accumulated
Amortization
       Intangible
Assets, Net
 
(in thousands)                           

Agency contracts

     $ 459,044         $ 138,105         $ 320,939   

Non-compete/non-solicit

       2,693           664           2,029   

Relationship with contracted caregivers

       11,118           5,765           5,353   

Trade names

       3,774           1,688           2,086   

Trade names (indefinite life)

       42,400           —             42,400   

Licenses and permits

       43,636           19,532           24,104   

Intellectual property

       904           301           603   
    

 

 

      

 

 

      

 

 

 
     $ 563,569         $ 166,055         $ 397,514   
    

 

 

      

 

 

      

 

 

 

For the three months ended December 31, 2011 and 2010, the amortization expense for continuing operations was $9.1 million and $9.0 million, respectively, and the amortization expense for discontinued operations for the three months ended December 31, 2010 was $0.2 million.

8. Related Party Transactions

Management Agreement

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.

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 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. The Company recorded $0.3 million of management fees and expenses for the three months ended December 31, 2011 and 2010. The accrued liability related to the management agreement was $0.1 million and $0.4 million at December 31, 2011 and September 30, 2011, respectively.

 

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Consulting Agreements

During fiscal 2011, the Company engaged Alvarez & Marsal Healthcare Industry Group (“Alvarez & Marsal”) to provide certain transaction advisory and other services. A Company 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 described in note 4, including the repurchase of 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 Vestar’s principals serves on the Board of Directors of Duff & Phelps Corporation but was not personally involved in this engagement. This engagement resulted in fees of approximately $0.2 million during the three months ended December 31, 2010 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 Minnesota which have various expiration dates extending out as far as July 2016. Related party lease expense was $1.0 million and $1.2 million for the three months ended December 31, 2011 and 2010, respectively. At the end of the three months ended December 31, 2011, the properties associated with certain of these leases were sold to an independent third party.

9. Fair Value Measurements

The Company measures and reports its 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, 2011 consist of:

 

September 30, September 30, September 30, September 30,

(in thousands)

     Total      Quoted
Market Prices
(Level 1)
       Significant Other
Observable  Inputs
(Level 2)
     Significant
Unobservable  Inputs
(Level 3)
 

Interest rate swap agreements

     $ (6,444    $ —           $ (6,444    $ —     

 

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Assets and liabilities recorded at fair value at September 30, 2011 consist of:

 

September 30, September 30, September 30, September 30,

(in thousands)

     Total      Quoted
Market Prices
(Level 1)
       Significant Other
Observable  Inputs
(Level 2)
     Significant
Unobservable  Inputs
(Level 3)
 

Interest rate swap agreements

     $ (6,744    $ —           $ (6,744    $ —     

Interest rate swap agreements. The fair value of the swap agreements was recorded in current liabilities (under Other accrued liabilities). The fair value of these agreements was determined based on pricing models and independent formulas using current assumptions that included swap terms, interest rates and forward LIBOR curves and the Company’s credit risk.

At December 31, 2011 and September 30, 2011, the carrying values of cash, accounts receivable, accounts payable and variable rate debt approximated fair value. The carrying value and fair value of the Company’s fixed rate debt instruments are set forth below:

 

September 30, September 30, September 30, September 30,
       December 31, 2011        September 30, 2011  

(in thousands)

     Carrying
Amount
       Fair
Value
       Carrying
Amount
       Fair
Value
 

Senior notes (issued February 9, 2011)

     $ 240,176         $ 231,875         $ 239,773         $ 228,750   

The Company estimated the fair value of the debt instruments using market quotes and calculations based on current market rates available.

10. 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, 2011, the Company’s effective income tax rate was 31.5% compared to an effective tax rate of 42.8% for the three months ended December 31, 2010. 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, 2011 is $4.9 million. There was no change in unrecognized tax benefits during the three months ended December 31, 2011. However, the Company expects changes to its unrecognized tax benefits within the next twelve months as a result of settlements, which it estimates will reduce this item by approximately $3.0 million. The Company’s policy is to recognize interest and penalties related to unrecognized tax benefits as charges to income tax expense.

11. 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 and/or 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.

 

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September 30, September 30, September 30, September 30,

For the three months ended December 31,

     Human
Services
       Post Acute
Specialty
Rehabilitation
Services
       Corporate      Consolidated  
       (In thousands)  

2011

                 

Net revenue

       229,476           44,957           —         $ 274,433   

Income (loss) from operations

       20,060           5,093           (12,658      12,495   

Total assets

       810,232           180,364           72,938         1,063,534   

Depreciation and amortization

       10,780           3,380           741         14,901   

Purchases of property and equipment

       2,526           3,594           142         6,262   

Income (loss) from continuing operations before income taxes

       3,152           2,040           (12,511      (7,319

2010

                 

Net revenue

       221,173           43,300           —         $ 264,473   

Income (loss) from operations

       20,626           4,858           (14,280      11,204   

Depreciation and amortization

       10,570           2,993           1,148         14,711   

Purchases of property and equipment

       2,133           1,136           689         3,958   

Income (loss) from continuing operations before income taxes

       13,604           3,629           (13,793      3,440   

Revenue from contracts with state and local governmental payors in the state of Minnesota, the Company’s largest state, which is included in the Human Services segment, accounted for 15% and 16% of the Company’s net revenue for the three months ended December 31, 2011 and 2010, respectively.

13. Accruals for Self-Insurance and Other Commitments and Contingencies

The Company maintains insurance for professional and general liability, workers’ compensation liability, automobile liability and health insurance liabilities that includes 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.

For professional and general liability, from October 1, 2010 through September 30, 2011, the Company was 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. Commencing October 1, 2011, the Company is self-insured for the first $4.0 million of each and every claim with no aggregate limit. 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.

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.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion of our financial condition and results of operations should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended September 30, 2011, 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, our operations have grown to 33 states. We provide residential services to approximately 11,000 clients, some of whom also receive periodic services. Approximately 16,000 clients receive periodic services from us.

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.

We have two reportable segments, Human Services and Post-Acute Speciality Rehabilitation Services (“SRS”). The Human Services segment provides home and community-based human services to adults and children with intellectual and/or developmental disabilities and to youth with emotional, behavioral and/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.

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 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.

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 long-term growth in our client base to certain trends that are increasing demand in our industry, including demographic, health-care and political developments.

 

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Table of Contents

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. And while our residential ARY services have been negatively impacted by a substantial decline in the number of children and adolescents in foster care placements during the last decade, this trend has led to significant increased demand for periodic, non-residential services to support at-risk youth and their families. Demand for our SRS services has also grown as faster emergency response and improved medical techniques have resulted in more people surviving a catastrophic injury. SRS services are increasingly sought out as a clinically-appropriate and less-expensive alternative to institutional care and as a “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 recent economic downturn, our government payors in several states have responded to deteriorating revenue collections by implementing provider rate reductions, including in the states of Arizona, California, Florida, Indiana and Minnesota. In total, rate reductions implemented from October 1, 2008 through December 31, 2011 have reduced annualized revenue by approximately $16 million or about 1.5% of fiscal 2011 revenue. In addition, the volume of referrals to our residential programs has also been constrained in many markets as payors have sought out in-home periodic services as an alternative to more expensive residential care. The termination of the enhanced federal Medicaid funding after June 30, 2011 contributed to significant budgetary challenges that confronted state governments for fiscal 2012, which began July 1, 2011 in most states. The result is that some of our public payors have implemented, or may implement in the coming months, additional rate reductions, particularly for our I/DD services, including our largest state payor, Minnesota, which announced rate reductions of approximately 1.5% for Medicaid Waiver and ICF Services effective September 1, 2011.

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 suffered rate reductions during and since the recent recession. 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 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

Various economic, fiscal, public policy and legal factors are contributing to an environment with an increased number of organic growth opportunities, particularly within the Human Services segment, and, as a result, we have a renewed emphasis on growing our business organically and making investments to support the effort. Our future growth will depend heavily on our ability to expand our current programs and identify and execute upon new opportunities. 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, 2011, operating losses on new starts for programs started within the previous 18 months were $2.0 million.

Acquisitions

As of December 31, 2011, we have completed 30 acquisitions since 2006, 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, 2011, we acquired three companies complementary to our business, two in the Human Services segment and one in the SRS segment, for $3.2 million.

 

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Table of Contents

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. During the first quarter of fiscal 2012, we derived approximately 90% of our net revenue from state, local and other 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.

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 and insurance costs. General and administrative expenses primarily include salaries and benefits for administrative employees, or employees that are not directly providing services, administrative occupancy costs as well as professional expenses such as accounting, consulting and legal 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, 2011, we owned 397 facilities and one office, and we leased 983 facilities and 270 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 1.1% and 1.0% of our net revenue for the three months ended December 31, 2011 and 2010, respectively. We have incurred professional and general liability claims and insurance expense for professional and general liability of $3.1 million and $2.7 million for the three months ended December 31, 2011 and 2010, respectively. Claims paid by us and our insurers for professional and general liability have increased sharply in recent years. Commencing October 1, 2010, our self-insured retentions substantially exceeded the amounts we previously had and we paid substantially higher premiums for our professional and general liability insurance. From October 1, 2010 to September 30, 2011, we were 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. Commencing October 1, 2011, we have been self-insured for the first $4.0 million of each and every claim without an aggregate limit.

 

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Table of Contents

Our ability to maintain and grow our earnings in the future is dependent upon growing revenue, obtaining increases in rates and/or controlling our expenses. In fiscal 2011, 2010 and 2009, we invested in infrastructure initiatives and business process improvements, which had a net negative impact on our margin. Beginning in fiscal 2011, we also increased our investment in organic growth initiatives. During fiscal 2012 we expect to significantly increase our activity in this area, focusing on states such as California and New Jersey that are still closing institutions.

Results of Operations

The following table sets forth income (loss) from operations as a percentage of net revenue (operating margin) for the periods indicated:

 

September 30, September 30, September 30, September 30,

For the three months ended December 31,

     Human Services     Post Acute  Specialty
Rehabilitation
Services
    Corporate      Consolidated  
(in thousands)         

2011

           

Net revenue

     $ 229,476      $ 44,957      $ —         $ 274,433   

Income (loss) from operations

       20,060        5,093        (12,658      12,495   

Operating margin

       8.7     11.3     —           4.6

2010

           

Net revenue

     $ 221,173      $ 43,300      $ —         $ 264,473   

Income (loss) from operations

       20,626        4,858        (14,280      11,204   

Operating margin

       9.3     11.2     —           4.2

Three months ended December 31, 2011 compared to three months ended December 31, 2010

Consolidated revenue for the three months ended December 31, 2011 increased by $10.0 million, or 3.8%, compared to revenue for the three months ended December 31, 2010. Revenue increased $5.2 million related to organic growth, including growth related to new programs and $4.8 million related to acquisitions that closed during and after the three months ended December 31, 2010. Modest organic growth was achieved despite the negative impact of rate reductions in some states, including Arizona, Florida and Minnesota.

Consolidated income from operations increased from $11.2 million or 4.2% of revenue, for the three months ended December 31, 2010 to $12.5 million or 4.6% of revenue, for the three months ended December 31, 2011.

In addition to the increase in revenue noted above, our operating margin was positively impacted as our health insurance expense decreased by $2.7 million for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010, as a result of a change in plan design effective January 1, 2011 and a significant reduction in the number of large claims compared to prior period.

In addition, our operating expenses for the three months ended December 31, 2010 included costs which we did not incur during the three months ended December 31, 2011, namely $0.7 million of additional costs related to our cost structure optimization efforts and $0.6 million of additional costs in consulting and legal costs related to a transaction which was not completed.

Partially offsetting the increase in income from operations, our direct labor costs increased in our Human Services segment as we increased staffing in advance of growth opportunities and filled vacancies. Also during the three months ended December 31, 2011, we recorded an additional $1.0 million in occupancy expense and $0.6 million in transportation expense, primarily related to acquisitions.

Interest expense increased by $11.6 million from the three months ended December 31, 2010 compared with the three months ended December 31, 2011 as a result of our refinancing in February 2011 (the “February 2011 Refinancing”). Our weighted average debt balance increased by $280.2 million and our weighted average interest rate increased from 5.5% during the three months ended December 31, 2010 to 9.3% for the three months ended December 31, 2011.

 

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Human Services

Human Services revenue for the three months ended December 31, 2011 increased by $8.3 million, or 3.8%, compared to the three months ended December 31, 2010. Revenue increased $5.1 million as a result of organic growth, including growth related to new programs, and $3.2 million related to acquisitions that closed during and after the three months ended December 31, 2010. Modest organic growth was achieved despite the negative impact of rate reductions in some states, including Arizona, Florida and Minnesota.

Income from operations decreased from $20.6 million during the three months ended December 31, 2010 to $20.1 million during the three months ended December 31, 2011 and operating margin decreased from 9.3% of revenue to 8.7% of revenue for the same periods.

Our operating margin was negatively impacted by an increase in direct labor costs as we increased staffing in advance of growth opportunities and filled vacancies. Also during the three months ended December 31, 2011, we recorded an additional $0.6 million in transportation expense and $0.5 million in occupancy expense primarily related to acquisitions in this segment.

Partially offsetting this decrease, our operating margin was positively impacted as our health insurance expense decreased by $2.5 million, as a result of a change in plan design effective January 1, 2011 and a significant reduction in the number of large claims compared to prior period.

Post-Acute Specialty Rehabilitation Services

Post-Acute Specialty Rehabilitation Services revenue for the three months ended December 31, 2011 increased by $1.7 million, or 3.8%, compared to the three months ended December 31, 2010. This increase was primarily due to growth of $1.6 million related to acquisitions that closed during and after the three months ended December 31, 2010 and $0.1 million related to organic growth, including growth related to new programs.

Income from operations increased from $4.9 million during the three months ended December 31, 2010 to $5.1 million during the three months ended December 31, 2011 and operating margin increased slightly from 11.2% to 11.3% for the same periods. Our operating margin was positively impacted by a decrease in labor costs and a decrease in health insurance expense as a result of a change in plan design effective January 1, 2011 and a significant reduction in the number of large claims compared to prior period.

Partially offsetting this increase, our operating margin was negatively impacted as we recorded an additional $0.5 million in occupancy expense primarily related to acquisitions in this segment.

Corporate

Total corporate expenses decreased by $1.6 million from the three months ended December 31, 2010 to $12.7 million for the three months ended December 31, 2011 as our expenses for the three months ended December 31, 2010 included costs which we did not incur during the three months ended December 31, 2011. During the three months ended December 31, 2010, we recorded an additional $0.7 million related to our cost structure optimization efforts and an additional $0.6 million in consulting and legal costs related to a transaction which was not completed.

Liquidity and Capital Resources

Our principal uses of cash are to meet working capital requirements, fund debt obligations and finance capital expenditures and acquisitions. Cash flows from operations have historically been sufficient to meet these cash requirements. Our principal sources of funds are cash flows from operating activities and available borrowings under our senior revolver (as defined below).

Operating activities

Cash flows used in operating activities was $1.6 million for the three months ended December 31, 2011 compared to cash flows provided by operating activities of $20.0 million for the three months ended December 31 2010. The decrease in cash flows was due to an increase in our working capital primarily due to an increase in our days sales outstanding to 54 days at December 31, 2011 from 48 days at September 30, 2011. Our days sales outstanding increased primarily due to temporary inefficiencies as we centralized certain billing and accounts receivable functions and introduced a new billing and accounts receivable system in certain locations. In addition, our cash flows from operations were negatively impacted by a decrease in our net income, which resulted primarily from an increase in interest expense.

 

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Investing activities

Net cash used in investing activities was $9.2 million and $6.5 million for the three months ended December 31, 2011 and 2010, respectively.

Cash paid for property and equipment for the three months ended December 31, 2011 was $6.3 million, or 2.3% of revenue, compared to $4.0 million, or 1.5% of revenue for the three months ended December 31, 2010. A significant portion of the increase related to cash paid for leasehold improvements and for vehicles.

During the three months ended December 31, 2011 we paid $3.2 million for three acquisitions, two in our Human Services segment and one in our SRS segment. During the three months ended December 31, 2010 we paid $2.9 million for three acquisitions, two in our Human Services segment and one in our SRS segment.

Financing activities

Net cash provided by financing activities was $10.6 million for the three months ended December 31, 2011 compared to $5.4 million of cash used in financing activities for the three months ended December 31, 2010.

At December 31, 2011, there was $12.0 million of outstanding borrowings and $63.0 million of availability under the senior revolver. We expect to continue to draw on the revolver during fiscal 2012 and we believe that available 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. Our increased cash interest payments after the February 2011 Refinancing and our investments in our growth initiatives have reduced our free cash flow in the business.

Our financing activities for the three months ended December 31, 2011 and 2010 included the repayment of long term debt of $1.3 million and $0.9 million, respectively. Our cash paid for principal increased as a result of the additional indebtedness incurred in the February 2011 refinancing.

Net cash used in financing activities for the three months ended December 31, 2010 also included contingent consideration payments of $3.3 million related to the IFCS acquisition, which we acquired in fiscal 2009.

Debt and Financing Arrangements

On February 9, 2011, we completed the February 2011 refinancing, which included entering into a senior credit agreement (the “senior credit agreement”) for senior secured credit facilities (the “senior secured credit facilities”) and issuing $250.0 million in aggregate principal amount of 12.50% senior notes due 2018 (the “senior notes”). We used the net proceeds from the senior secured credit facilities ($520.9 million) and the senior notes ($238.7 million), 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 $9.6 million to NMH Holdings related to a tax sharing arrangement; (iv) declare a $219.7 million dividend to NMH Holdings, LLC (“Parent”), which in turn made a distribution to NMH Holdings, which used $206.4 million cash proceeds of the distribution to repurchase $210.9 million principal amount of the NMH Holdings notes at a premium, not including $13.3 million principal amount of NMH Holdings notes we held as an investment and that were also repurchased; and (v) pay related fees and expenses.

Senior Secured Credit Facilities

We entered into senior secured credit facilities, consisting of a (i) six-year $530.0 million term loan facility (the “term loan”), of which $50.0 million was deposited in a cash collateral account in support of issuance of letters of credit under the institutional letter of credit facility and a (ii) $75.0 million five-year senior secured revolving credit facility (the “senior revolver”). All of our obligations under the senior secured credit facilities are guaranteed by Parent and certain of our existing subsidiaries.

At our option, we may add one or more new term loan facilities or increase the commitments under the 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 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.

 

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The senior credit agreement contains a number of covenants including, among other things, limitations on the Company’s ability to incur additional debt, create liens on assets, transfer or sell assets, pay dividends, redeem stock or make other distributions or investments, and engage in certain transactions with affiliates. The senior credit agreement contains affirmative covenants and events of default. The senior credit agreement also requires us to maintain certain financial covenants, as described under “Covenants” below.

Term loan

The $530.0 million term loan was issued at a price equal to 98.5% of its face value and amortizes one percent per year, paid quarterly, with the remaining balance payable at maturity. The senior credit agreement also includes a provision for the prepayment of a portion of the outstanding term loan amounts beginning in fiscal 2011 equal to an amount ranging from 0 to 50% of a calculated amount, depending on our leverage ratio, if we generate certain levels of cash flow, sell certain assets or incur other indebtedness, subject to certain exceptions. We are required to repay the term loan portion of the senior credit facilities in quarterly principal installments of 0.25% of the principal amount, with the balance payable at maturity. The variable interest rate on the term loan bears interest at (i) a rate equal to the greater of (a) the prime rate (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%, at our option. At December 31, 2011, the variable interest rate on the term loan was 7.0%.

Senior revolver

We had $12.0 million of borrowings and $63.0 million of availability under the senior revolver at December 31, 2011 and had $35.8 million of standby letters of credit issued under the institutional letter of credit facility primarily related to our workers’ compensation insurance coverage. Letters of credit can be issued under our institutional letter of credit facility up to the $50.0 million credit collateral account. Letters of credit in excess of that amount reduce availability under our senior revolver. The interest rates for any borrowings under the senior revolver are the same as outlined for the term loan.

The 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 senior revolver.

Senior Notes

On February 9, 2011, we issued $250.0 million in aggregate principal amount of the senior notes 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 12.50% 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.

Covenants

The senior credit agreement and the indenture governing the senior notes contain negative financial and non-financial covenants, including, among other things, limitations on our ability to incur additional debt, create liens on assets, transfer or sell assets, pay dividends, redeem stock or make other distributions or investments, and engage in certain transactions with affiliates. We were in compliance with these covenants as of December 31, 2011. In addition, in the case of the senior credit agreement, we are required to maintain at the end of each fiscal quarter 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

 

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most recently completed four fiscal quarters. We are also required to maintain at the end of each fiscal quarter 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.

As of December 31, 2011, our consolidated leverage ratio was 6.33 to 1.00, as calculated in accordance with the senior credit agreement and our consolidated interest coverage ratio was 1.61 to 1.00, as calculated in accordance with the senior credit agreement. As of December 31, 2011, total debt, net of cash and cash equivalents, was $747.2 million. Under the senior credit agreement, consolidated adjusted EBITDA is defined as net income before interest expense and interest income, income taxes, depreciation and amortization, further adjusted to add back certain non-cash charges, fees under the management agreement with our equity sponsor, proceeds of business insurance, certain expenses incurred under indemnification or refunding provisions for acquisitions, certain start-up losses, non-cash compensation expense, transaction bonuses, unusual or non-recurring losses, charges, severance costs and relocation costs and deductions attributable to minority interests, business optimization expenses and further adjusted to subtract unusual or non-recurring income or gains, income tax credits to the extent not netted, non-cash income and interest income and gains on interest rate hedges, and further adjusted for certain other items including EBITDA and pro forma adjustments from acquired businesses and exclusion of discontinued operations.

Set forth below is a reconciliation of consolidated adjusted EBITDA, as calculated under the credit agreement, to net loss for the most recently completed four fiscal quarters ended December 31, 2011:

 

September 30,
       (In thousands)  

Net loss

     $ (40,987

Loss from discontinued operations, net of tax

       4,889   

Benefit for income taxes

       (18,202

Gain from available for sale investment security

       (3,018

Interest income

       (21

Interest income from related party

       (190

Interest expense

       73,359   

Depreciation and amortization

       62,091   

Extinguishment of debt

       19,278   

Non-cash impairment charge

       5,993   

Stock-based compensation

       3,840   

Restructuring expense

       2,280   

Discretionary recognition bonuses

       2,361   

Management fee of related party

       1,241   

Lease termination fee

       713   

Acquisition costs

       323   

Claims made insurance liability

       580   

Terminated transaction costs

       (35

(Gain) loss on disposal of assets

       (33

Change in fair value of contingent consideration

       (701

Franchise taxes, transaction fees, costs, and expenses

       (8

Acquired EBITDA

       2,268   

Operating losses from new starts

       1,955   
    

 

 

 

Consolidated adjusted EBITDA per the senior credit agreement

     $ 117,976   
    

 

 

 

Set forth below is an annualized calculation of consolidated interest expense as of December 31, 2011, as calculated under the credit agreement:

 

September 30,
       (In thousands)  

Senior term loan

     $ 37,512   

Senior subordinated notes

       31,293   

Interest rate swap agreements

       3,230   

Unused line of credit

       573   

Capital leases

       424   

Standby letters of credit

       92   

Interest income

       (23
    

 

 

 

Consolidated interest expense per the senior credit agreement

     $ 73,101   
    

 

 

 

 

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The consolidated leverage ratio and the consolidated interest coverage ratios are material components of the senior credit agreement and non-compliance with these ratios could prevent us from borrowing under the senior revolver and would result in a default under the senior credit agreement.

Contractual Commitments Summary

The following table summarizes our contractual obligations and commitments as of December 31, 2011:

 

September 30, September 30, September 30, September 30, September 30,
       Total        Less Than
1 Year
       1-3 Years        3-5 Years        More Than
5 Years
 
       (In thousands)  

Long-term debt obligations(1)

     $ 1,111,502           85,843           80,426           144,947           800,286   

Operating lease obligations(2)

       143,012           39,059           54,074           30,430           19,449   

Capital lease obligations

       9,168           316           993           1,182           6,677   

Standby letters of credit

       35,812           35,812           —             —             —     
    

 

 

      

 

 

      

 

 

      

 

 

      

 

 

 

Total obligations and commitments(3)

     $ 1,299,494         $ 161,030         $ 135,493         $ 176,559         $ 826,412   
    

 

 

      

 

 

      

 

 

      

 

 

      

 

 

 

 

(1)

Amounts represent the principal amount of our long-term debt and the expected cash payments for interest on our long-term debt based on the interest rates in place and amounts outstanding at December 31, 2011.

 

(2)

Includes the fixed rent payable under the leases and does not include additional amounts, such as taxes, that may be payable under the leases.

 

(3)

The table above does not include $4.9 million of unrecognized tax benefits for uncertain tax positions and $2.3 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, 2011, 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, except for the adoption of ASU 2010-24 during the first quarter of fiscal 2012. This adoption clarifies that companies should not net insurance recoveries against a related claim liability and the amount of the claim liability should be determined without consideration of insurance recoveries. This adoption resulted in an increase of $37.2 million in Other assets and a corresponding increase in Other long-term liabilities on the Company’s December 31, 2011 balance sheet and there was no impact on our results of operations or cash flows. In addition, no triggering events have come to our attention pursuant to our review of goodwill that would indicate impairment as of December 31, 2011.

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, 2011.

 

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Forward-Looking Statements

Some of the matters discussed in this report may constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

These statements relate to future events or our future financial performance, 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 investments in our infrastructure and business process improvements, our margins and our liquidity. 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 or other funding or changes in budgetary priorities by federal, state and local governments;

 

   

changes in reimbursement rates, policies or payment practices by our payors;

 

   

our substantial amount of debt, our ability to meet our debt service obligations and our ability to incur additional debt;

 

   

an increase in the number and nature of pending legal proceedings and the outcomes of those proceedings;

 

   

failure to take advantage of organic growth opportunities;

 

   

our ability to maintain, expand and renew existing services contracts and to obtain additional contracts;

 

   

our ability to acquire new licenses or to maintain our status as a licensed service provider in certain jurisdictions;

 

   

our ability to establish and maintain relationships with government agencies and advocacy groups;

 

   

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 attract and retain experienced personnel, including members of our senior management team;

 

   

increased or more effective competition;

 

   

successful integration of acquired businesses;

 

   

credit and financial market conditions;

 

   

changes in interest rates;

 

   

the potential for conflict between the interests of our majority equity holder and those of our debt holders; and

 

   

government regulations, changes in government regulations and our ability to comply with such regulations.

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.

We are exposed to changes in interest rates as a result of our outstanding variable rate debt. To reduce the interest rate exposure related to the variable debt, we entered into an interest rate swap in a notional amount of $400.0 million effective March 31, 2011 and ending September 30, 2014. Under the terms of the swap, we receive from the counterparty a quarterly payment based on a rate equal

 

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to the greater of 3-month LIBOR and 1.75% per annum, and we make payments to the counterparty based on a fixed rate of 2.5% per annum, in each case on the notional amount of $400.0 million, settled on a net payment basis. Based on the applicable margin of 5.25% under our term loan facility, this swap effectively fixes our cost of borrowing for $400.0 million of our term loan debt at 7.8% per annum for the term of the swap.

As a result of the interest rate swap, the variable rate debt outstanding was effectively reduced from $538.0 million outstanding to $138.0 million outstanding as of December 31, 2011. The variable rate debt outstanding relates to the term loan and the senior revolver, which bear interest at (i) a rate equal to the greater of (a) the prime rate (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%, at our option. A 1% increase in the interest rate on our floating rate debt would increase cash interest expense on the floating rate debt by approximately $1.4 million per annum.

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 and the President (principal executive officers) and the Chief Financial Officer (principal 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, 2011, 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, 2011.

(b) Changes in Internal Control over Financial Reporting

During the quarter ended December 31, 2011, we continued to transition certain field billing and accounts receivable functions into a centralized shared services center. This centralization is expected to continue in a phased approach over the next several years. As part of this centralization, as well as the continued implementation of our new billing and accounts receivable system for additional business units, we continue to refine and optimize our new billing and accounts receivable process and related system in a majority of our operations. This has affected, and will continue to affect, the processes that impact our internal control over financial reporting. We will continue to review the related controls and may take additional steps to ensure that they remain effective.

Except for the continuing centralization and 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.

 

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See “Part II. Item 1A. Risk Factors” and “Part I. Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional information

Item 1A. Risk Factors.

Reductions or changes in Medicaid funding or changes in budgetary priorities by the federal, 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 75% 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.

Efforts at the federal level to reduce the federal budget deficit pose risk for reductions in federal Medicaid matching funds to state governments. The Joint Select Committee on Deficit Reduction’s failure to meet the deadline imposed by the Budget Control Act of 2011 triggers automatic across-the-board cuts to discretionary funding, as well as a 2% reduction to Medicare, but specifically exempts Medicaid payments to states. While this development does not reduce federal Medicaid funding, reductions in other federal payments to states could put additional stress on state budgets, with the potential to negatively impact the ability of states to provide the state Medicaid matching funds necessary to maintain or increase the federal financial contribution to the program. Future efforts by Congress to adopt proposals to reduce the federal budget deficit could have a negative impact on state Medicaid budgets, including proposals to provide states with more flexibility to determine Medicaid benefits, eligibility or provider payments through the use of block grants or streamlined waiver approvals, as well as those that would reduce the amount of federal Medicaid matching funding available to states by curtailing the use of provider taxes or by adjusting the Federal Medical Assistance Percentage (FMAP). Additionally, any new Medicaid-funded benefits and requirements established by the Congress, particularly those included in The Patient Protection and Affordable Care Act of 2010, that mandate certain uses for Medicaid funds could have the effect of diverting those funds from the services we provide.

Budgetary pressures facing state governments, as well as other economic, industry, and political factors, could cause state governments to limit spending, which could significantly reduce our revenue, referrals, margins and profitability, and adversely affect our growth strategy. Governmental agencies generally condition their contracts with us upon a sufficient budgetary appropriation. If a government agency does not receive an appropriation sufficient to cover its contractual obligations with us, it may terminate a contract or defer or reduce our reimbursement. In addition, there is risk that previously appropriated funds could be reduced through subsequent legislation. Many states in which we operate have recently experienced unprecedented budgetary deficits and have implemented or are considering initiating service reductions, rate freezes and/or rate reductions, including states such as Minnesota, California, Florida, 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 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. The termination of the enhanced federal Medicaid funding after June 30, 2011 contributed to significant budgetary challenges that confronted state governments for fiscal 2012, which began July 1, 2011 in most states. The result is that some of our public payors have implemented, or are likely to implement in the coming months, additional rate reductions, particularly for our I/DD services. 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.

 

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Our level of indebtedness could adversely affect our liquidity and ability to raise additional capital to fund our operations, and it could limit our ability to react to changes in the economy or our industry.

We have a significant amount of indebtedness and substantial leverage. As of December 31, 2011, we had total indebtedness of $797.2 million. During three months ended December 31 2011, we incurred net borrowings of $12.0 million under our senior revolver and we expect to continue to draw on the revolver during fiscal 2012. As we make new investments in organic growth and meet increased cash principal and interest payments compared with fiscal 2011, we will have less free cash flow in the business. Interest on our indebtedness is payable entirely in cash. Our annualized interest expense as of December 31, 2011, as calculated in accordance with the credit agreement, was $73.1 million as compared to $43.2 million at September 30, 2010. As of December 31, 2011, our consolidated leverage ratio was 6.33 to 1.00, as calculated in accordance with the senior credit agreement.

Our substantial degree of leverage could have important consequences, including the following:

 

   

it may significantly curtail our acquisitions program and may limit our ability to invest in our infrastructure and in growth opportunities;

 

   

it may diminish our ability to obtain additional debt or equity financing for working capital, capital expenditures, debt service requirements 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 the portion of our variable interest rate borrowings under the senior secured credit facilities that have not been hedged 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 notes tendered to us if there is a change of control, which would constitute a default under the senior credit agreement governing our senior secured credit facilities.

Subject to restrictions in the indenture governing our senior notes and the 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 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, 2011, our aggregate rental payments for these leases, including taxes and operating expenses, were $12.1 million. These obligations could further increase the risks described above.

Covenants in our debt agreements restrict our business in many ways.

The senior credit agreement governing the 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;

 

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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 senior credit agreement governing the senior secured credit facilities also requires the Company and its subsidiaries to maintain specified financial ratios and satisfy other financial condition tests. Our ability to meet those financial ratios and tests may be affected by events beyond our control, and we cannot assure you that we will meet those tests. The breach of any of these covenants or financial ratios could result in a default under the senior secured credit facilities and the lenders could elect to declare all amounts borrowed there under, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness.

The nature of our operations subjects 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 or ask for recoupment of amounts paid. 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.

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 and increase future insurance costs. As of October 1, 2010, we were 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. Since October 1, 2011, we have been self-insured for the first $4.0 million of each and every claim with no aggregate limit. We may be subject to increased self-insurance

 

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retention limits in the future which could have a negative impact on our results. 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 employment practice claims and 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. 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.

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 materially 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, private whistleblowers, or Medicaid auditors will not challenge our practices. Such a challenge could result in a material adverse effect on our business.

If any of the state, local and other government payors 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 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.

 

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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.

We are making investments to expand existing services, win new business and grow revenue, and we may not realize the anticipated benefits of those investments.

In order to grow our business, we must capitalize on opportunities to expand existing services and win new business, some of which require an investment of capital. For example, states such as California and New Jersey are in the process of closing institutions and their former residents will need care in community-based settings such as ours, and many payors are now seeking in-home periodic services as an alternative to residential care, especially for at-risk youth who otherwise would be placed in foster care. In fiscal 2011, we began increasing the amount spent on growth initiatives, such as new starts, and we expect to significantly increase our growth investments during fiscal 2012. If we fail to identify the evolving needs of our payors and respond with service offerings that meet their fiscal and programmatic requirements, we may not realize the anticipated benefits of our investments and the results of our operations may suffer.

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, 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.

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.

 

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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.

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 or the need to increase wages to retain staff, health care costs and other personnel costs, and adverse changes in client service models. We typically cannot recover our increased labor costs from payors and must absorb them ourselves. 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 imposed new mandates on employers beginning in January 2011 and will continue to impose new mandates through 2014. Given the composition of our workforce, these mandates could materially increase our costs, if the law survives court and political challenges.

Although our employees are generally not unionized, we have one business in New Jersey with approximately fifty 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.

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.

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.

 

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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.

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.

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.

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

 

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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 five 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. MIC audits expanded during fiscal 2011 and we expect that will continue throughout fiscal 2012. In addition to MICs, several other payors, including the state Medicaid agencies, have increased their review activities, including through the use of Recovery Audit Contractor (“RAC”) programs. State Medicaid agencies are required to have RAC programs in place by January 1, 2012 unless granted an extension by CMS. RACs are private entities which will perform audits on a contingency fee basis, giving them an incentive to identify underpayments, from which they may be permitted to extrapolate disproportionately large penalties and fines.

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.

No evaluation can provide complete assurance that our internal controls will operate as intended. Although we did not identify material weaknesses in our internal controls in connection with our audits for fiscal 2011 and fiscal 2010, we did identify material weaknesses in fiscal 2009 and fiscal 2008. Some of those weaknesses resulted in errors that led to an adjustment of property and equipment by $1.8 million in a prior period.

The decentralized nature of our operations and manual nature of many of our controls increases our risk of control deficiencies. We have gradually been centralizing and automating certain of those controls, and we may in the future identify material weaknesses in connection with this implementation. In addition, future acquisitions may present challenges in implementing appropriate 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.

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.

Current credit and economic conditions could have a material adverse effect on our cash flows, liquidity and financial condition.

Tax revenue continued to be constrained in many jurisdictions due to the impact of the recent 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. Due to the general tightening of the credit markets over the last several years, our government payors or other counterparties that owe us money, such as counterparties to swap contracts, could be delayed in obtaining, or may not be able to obtain, necessary funding and/or financing to meet their cash-flow needs. In the aftermath of the downgrading of the Federal government’s credit rating by Standard & Poor’s, it is possible there will be downgrades of state credit ratings and if they occur, this could make it more expensive for states to

 

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finance their cash-flow needs and put additional pressure on state budgets. Delays in payment could have a material adverse effect on our cash flows, liquidity and financial condition. In the event that our payors or other counterparties are financially unstable or 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.

Because a 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 portion of our indebtedness, including borrowings under the senior revolver and borrowings under the term loan facility for which we have not hedged our interest rate exposure under an interest rate swap agreement, 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, 2011, we had $538.0 million of floating rate debt outstanding before giving effect to the interest rate swap agreement. As a result of the interest rate swap agreement, the floating rate debt has been effectively reduced to $138.0 million. A 1% increase in the interest rate on our floating rate debt would increase cash interest expense of the floating rate debt by approximately $1.4 million per annum. If interest rates increase dramatically, we could be unable to service our debt.

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, 2011, 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% applicable for Medicaid Waiver services took effect in Minnesota on July 1, 2009 and, more recently, the state implemented a 1.5% rate cut for both Medicaid Waiver and ICF Services effective September 1, 2011. 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.

 

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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.

Our success depends on our ability to manage growing and changing operations and successfully optimize our cost structure.

Since 2003, 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 and accounting functions being performed at the local level. This requires us to expend significant resources maintaining 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 support further 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 restructuring some of our field administrative functions. To the extent these optimization efforts and 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.

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. Furthermore, a loss of health care information could result in potential penalties in certain of our businesses if we fail to comply with privacy and security standards in violation of HIPAA.

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 58.5% and 62.2% of the total assets on our consolidated balance sheets as of December 31, 2011 and September 30, 2011, 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.

 

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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. During fiscal 2011, we wrote-off $14.5 million, $5.8 million of which is recorded separately as discontinued operations in the consolidated statements of operations, for the write-off of goodwill, non-compete agreements, agency contracts, licenses and permits for underperforming programs as well as an impairment charge related to indefinite-lived intangible assets. We may record similar charges in the future and such charges could have a material adverse effect on our financial condition and results of operations.

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 organic growth opportunities, 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 of NMH Investment, LLC (“NMH Investment”) were sold during the three months ended December 31, 2011.

Repurchases of Equity Securities

No equity securities of the Company or of NMH Investment were repurchased during the three months ended December 31, 2011.

Dividends

Any determination to pay dividends will be at the discretion of our board of directors and will depend on then-existing conditions, including our financial condition, results of operations, contractual restrictions, capital requirements, business prospects and other factors our board of directors deems relevant. In addition, our current financing arrangements limit the cash dividends we may pay in the foreseeable future. We are restricted from paying dividends to Parent in excess of $15 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 exceptions.

It em 3. Defaults Upon Senior Securities.

None.

Item 4. Mine Safety Disclosures.

None.

It em 5. Other Information.

None.

Item 6. Exhibits.

The Exhibit Index is incorporated herein by reference.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

   

NATIONAL MENTOR HOLDINGS, INC.

February 14, 2012

   

By:

 

/s/ Denis M. Holler

     

Denis M. Holler

     

Its: 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    National Mentor Holdings, LLC Executive Deferred Compensation Plan, Fourth Amendment and Restatement Adopted December 27, 2011, Effective as of January 1, 2011    Incorporated by reference to Exhibit 10.8.1 of the National Mentor Holdings, Inc. Form 10-K for fiscal year ended September 30, 2011 (the “Fiscal 2011 10-K”)
  10.2    The MENTOR Network Human Services and Corporate Management Incentive Compensation Plan, Second Amendment and Restatement, Adopted December 27, 2011, Effective October 1, 2011    Incorporated by reference to Exhibit 10.12 of the Fiscal 2011 10-K
  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
  101       Interactive Data Files   

 

*

Management contract or compensatory plan or arrangement.

 

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