10-Q 1 g76086e10-q.txt ADVOCAT INC. UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q CHECK ONE: [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED: MARCH 31, 2002 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSACTION PERIOD FROM _________ TO _________. COMMISSION FILE NO.: 1-12996 ADVOCAT INC. ------------ (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 62-1559667 ------------------------------- --------------------------------- (STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.) INCORPORATION OR ORGANIZATION) 277 MALLORY STATION ROAD, SUITE 130, FRANKLIN, TN 37067 ------------------------------------------------------- (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (615) 771-7575 -------------- (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) NONE ------------------------- (FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT.) INDICATE BY CHECK MARK WHETHER THE REGISTRANT: (1) HAS FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS. YES [X] NO [ ] 5,493,287 ------------------------------------------- (OUTSTANDING SHARES OF THE ISSUER'S COMMON STOCK AS OF MAY 14, 2002) 1 PART I. FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS ADVOCAT INC. INTERIM CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS, AND UNAUDITED)
MARCH 31, DECEMBER 31, 2002 2001 --------- ------------ CURRENT ASSETS: Cash and cash equivalents $ 2,207 $ 3,426 Receivables, less allowance for doubtful accounts of $5,845 and $5,453, respectively 13,890 15,693 Inventories 537 550 Prepaid expenses and other assets 1,133 2,111 -------- -------- Total current assets 17,767 21,780 -------- -------- PROPERTY AND EQUIPMENT, at cost 91,975 90,669 Less accumulated depreciation and amortization (30,115) (28,790) -------- -------- Net property and equipment 61,860 61,879 -------- -------- OTHER ASSETS: Deferred financing and other costs, net 495 565 Deferred lease costs, net 1,826 1,878 Assets held for sale or redevelopment 1,064 1,064 Investments in and receivables from joint ventures 2,505 2,500 Other 1,347 1,404 -------- -------- Total other assets 7,237 7,411 -------- -------- $ 86,864 $ 91,070 ======== ========
(Continued) 2 ADVOCAT INC. INTERIM CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS, AND UNAUDITED) (CONTINUED)
MARCH 31, DECEMBER 31, 2002 2001 --------- ------------ CURRENT LIABILITIES: Current portion of long-term debt $ 21,775 $ 25,006 Short-term debt 33,699 33,719 Trade accounts payable 7,195 8,409 Accrued expenses: Payroll and employee benefits 5,233 5,482 Interest 331 179 Self-insurance reserves 6,209 7,894 Other 4,798 5,520 -------- -------- Total current liabilities 79,240 86,209 -------- -------- NONCURRENT LIABILITIES: Long-term debt, less current portion 4,573 4,613 Self-insurance reserves, less current portion 19,800 14,335 Other 3,346 2,943 -------- -------- Total noncurrent liabilities 27,719 21,891 -------- -------- COMMITMENTS AND CONTINGENCIES SERIES B REDEEMABLE CONVERTIBLE PREFERRED STOCK authorized 600,000 shares, $.10 par value, 393,658 shares issued and outstanding at March 31, 2002 and December 31, 2001, respectively, at redemption value 3,646 3,589 -------- -------- SHAREHOLDERS' EQUITY: Series A Preferred stock, authorized 400,000 shares, $.10 par value, none issued and outstanding -- -- Common stock, authorized 20,000,000 shares, $.01 par value, 5,493,000 issued and outstanding at March 31, 2002 and December 31, 2001, respectively 55 55 Paid-in capital 15,908 15,908 Accumulated deficit (39,704) (36,582) -------- -------- Total shareholders' equity (23,741) (20,619) -------- -------- $ 86,864 $ 91,070 ======== ========
The accompanying notes are an integral part of these interim consolidated balance sheets. 3 ADVOCAT INC. INTERIM CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS, AND UNAUDITED)
THREE MONTHS ENDED MARCH 31, ---------------------------- 2002 2001 --------- ---------- REVENUES: Patient revenues $ 40,691 $ 38,312 Resident revenues 10,179 10,420 Management fees 679 911 Interest 25 46 -------- -------- Net revenues 51,574 49,689 -------- -------- EXPENSES: Operating 43,728 39,735 Lease 5,180 5,175 General and administrative 3,159 3,235 Interest 1,092 1,516 Depreciation and amortization 1,383 1,411 -------- -------- Total expenses 54,542 51,072 -------- -------- LOSS BEFORE INCOME TAXES (2,968) (1,383) PROVISION FOR INCOME TAXES 93 90 -------- -------- NET LOSS $ (3,061) $ (1,473) ======== ======== BASIC AND DILUTED LOSS PER SHARE: Basic $ (.56) $ (.27) ======== ======== Diluted $ (.56) $ (.27) ======== ======== WEIGHTED AVERAGE SHARES: Basic 5,493 5,492 ======== ======== Diluted 5,493 5,492 ======== ========
The accompanying notes are an integral part of these interim consolidated financial statements. 4 ADVOCAT INC. INTERIM CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (IN THOUSANDS AND UNAUDITED)
THREE MONTHS ENDED MARCH 31, ---------------------------- 2002 2001 --------- ---------- NET LOSS $ (3,061) $ (1,473) OTHER COMPREHENSIVE INCOME (LOSS): Foreign currency translation adjustments (95) (676) Income tax benefit 35 249 -------- -------- (60) (427) -------- -------- COMPREHENSIVE LOSS $ (3,121) $ (1,900) ======== ========
The accompanying notes are an integral part of these interim consolidated financial statements. 5 ADVOCAT INC. INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS AND UNAUDITED)
THREE MONTHS ENDED MARCH 31, ---------------------------- 2002 2001 ---------- --------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss (3,061) $ (1,473) Items not involving cash: Depreciation and amortization 1,383 1,411 Provision for doubtful accounts 752 760 Provision for self-insured professional liability 4,838 2,330 Equity in earnings in joint ventures (31) (33) Amortization of deferred balances 132 258 Amortization of discount on non-interest bearing promissory note 11 67 Series B redeemable convertible preferred stock dividends 57 58 Provision for leases in excess of cash payments 369 406 Changes in other assets and liabilities: Receivables 1,005 (933) Inventories 13 86 Prepaid expenses and other assets 1,020 354 Trade accounts payable and accrued expenses (3,067) (911) ------- -------- Net cash provided by operating activities 3,421 2,380 ------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment, net (1,348) (727) Investment in TDLP -0- (609) Mortgages receivable, net 15 155 Investment in and advances (to) from joint ventures, net 22 269 TDLP partnership distributions -0- 136 ------- -------- Net cash used in investing activities (1,311) (776) ------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Net proceeds from (repayment of) bank line of credit (2,812) (2,804) Repayment of debt obligations (490) (1,180) Advances to TDLP, net -0- (515) Financing costs (27) (109) ------- -------- Net cash used in financing activities (3,329) (4,608) ------- --------
(Continued) 6 ADVOCAT INC. INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS AND UNAUDITED) (CONTINUED)
THREE MONTHS ENDED MARCH 31, ---------------------------- 2002 2001 --------- ---------- DECREASE IN CASH AND CASH EQUIVALENTS $ (1,219) $ (3,004) CASH AND CASH EQUIVALENTS, beginning of period 3,426 4,496 -------- -------- CASH AND CASH EQUIVALENTS, end of period $ 2,207 $ 1,492 ======== ======== SUPPLEMENTAL INFORMATION: Cash payments of interest $ 852 $ 1,388 ======== ======== Cash payments (refunds) of income taxes, net $ -0- $ -0- ======== ========
The accompanying notes are an integral part of these interim consolidated financial statements. 7 ADVOCAT INC. NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2001 AND 2000 1. BUSINESS Advocat Inc. (together with its subsidiaries, "Advocat" or the "Company") provides long-term care services to nursing home patients and residents of assisted living facilities in 12 states, primarily in the Southeast, and four Canadian provinces. The Company's facilities provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care facilities, the Company offers a variety of comprehensive rehabilitation services as well as medical supply and nutritional support services. As of March 31, 2002, the Company operates 116 facilities consisting of 62 nursing homes with 6,992 licensed beds and 54 assisted living facilities with 5,354 units. The Company owns 13 nursing homes, leases 34 others, and manages 15 nursing homes. The Company owns 16 assisted living facilities, leases 24 others, and manages the remaining 14 assisted living facilities. The Company holds a minority interest in seven of these managed assisted living facilities. The Company operates 49 nursing homes and 32 assisted living facilities in the United States and 13 nursing homes and 22 assisted living facilities in Canada. The Company operates facilities in Alabama, Arkansas, Florida, Georgia, Kentucky, North Carolina, Ohio, South Carolina, Tennessee, Texas, Virginia, West Virginia and the Canadian provinces of Alberta, British Columbia, Nova Scotia and Ontario. In March 2002, the Company entered into a letter of intent with Pierce Management Group and related persons (collectively, "Pierce"), pursuant to which the 13 leases with the former principal owners or affiliates of Pierce will be terminated and leases on two additional assisted living facilities will be assumed by Pierce, each with an effective date to be determined upon satisfactory negotiation of a Lease Termination and Operations Transfer Agreement (the "Pierce Agreement"). Effective April 30, 2002, the Company completed the Pierce Agreement with respect to the 13 facilities leased from the former principal owners or affiliates of Pierce. As a result, the Company was relieved of its future obligations with respect to these 13 leases. The leases on the two additional assisted living facilities will be similarly terminated, with an effective date to be determined upon satisfactory transfer of the licenses of these facilities. It is expected that this transfer will occur effective June 1. The Company will incur a write-down in the second quarter of 2002 of the remaining net book value of these facilities, estimated to be approximately $800,000. In recent periods, the long-term health care environment has undergone substantial change with regards to reimbursement and other payor sources, compliance regulations, competition among other health care providers and relevant patient liability issues. The Company continually monitors these industry developments as well as other factors that affect its business. See Item 2 for further discussion of recent changes in the long-term health care industry and the related impact on the operations of the Company. 8 2. BASIS OF FINANCIAL STATEMENTS The interim consolidated financial statements for the three month periods ended March 31, 2002 and 2001, included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of management of the Company, the accompanying interim consolidated financial statements reflect all adjustments necessary to present fairly the financial position at March 31, 2002 and the results of operations and the cash flows for the three month periods ended March 31, 2002 and 2001. The results of operations for the three month periods ended March 31, 2002 and 2001 are not necessarily indicative of the operating results for the entire respective years. These interim financial statements should be read in connection with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2001. The accompanying consolidated financial statements have been prepared assuming that Advocat Inc. (the "Company") will continue as a going concern. The Company has incurred operating losses in the three months ended March 31, 2002 and the years ended December 31, 2001, 2000 and 1999 and has limited resources available to meet its operating, capital expenditure and debt service requirements during 2002. The Company has a net working capital deficit of $61.5 million as of March 31, 2002. The Company has $33.7 million of scheduled debt maturities during the next 12 months and is in default of certain debt covenants contained in other debt instruments. Effective March 9, 2001, the Company also obtained professional liability insurance coverage that, based on historical claims experience, could be substantially less than the claims that could be incurred during 2001 and 2002 and is less than the coverage required by certain of the Company's debt and lease agreements. As a result, the Company is effectively self-insured. The ultimate payments on professional liability claims accrued as of March 31, 2002 and claims that could be incurred during the remainder of 2002 could require cash resources during 2002 that would be in excess of the Company's available cash or other resources. The Company is also not in compliance with certain lease and debt agreements, including financial covenants, insurance requirements and other obligations, that allow the Company's primary lessor the right to terminate the lease agreements and assume operating rights with respect to the leased properties and allow the holders of substantially all of the Company's debt to demand immediate repayment. Although the Company does not anticipate that such demands will be made, the continued forbearance on the part of the Company's primary lessor and lenders cannot be assured at this time. Accordingly, the Company has classified the related debt principal amounts as current liabilities in the accompanying consolidated financial statements as of March 31, 2002. Given that events of default exist under the Company's working capital line of credit, there can be no assurance that the lender will continue to provide working capital advances. At a minimum, the Company's cash requirements during 2002 include funding operations (including potential payments related to professional liability claims), capital expenditures, scheduled debt service, and working capital requirements. No assurance can be given that the Company will have sufficient cash to meet these requirements. 9 The majority of the Company's lenders have the right to force immediate payment of outstanding debt. The Company's scheduled debt maturities during the next twelve months total $33.7 million. The existing defaults in the Company's lease agreements covering a majority of its United States nursing facilities allows the lessor the right to terminate the lease agreements. The property and equipment, including leasehold improvements, related to these facilities total approximately $4.8 million as of March 31, 2002. Management continues to focus on efforts to increase revenues and to minimize future expense increases through the elimination of excess operating costs. Management will also attempt to minimize professional liability claims in future periods by vigorously defending itself against all such claims and through the additional supervision and training of staff employees. The Company is unable to predict if it will be successful in reducing operating losses, in negotiating waivers, amendments, or refinancings of outstanding debt, or if the Company will be able to meet any amended financial covenants in the future. Any demands for repayment by lenders, the inability to obtain waivers or refinance the related debt or the termination of the lease agreements would have a material adverse impact on the financial position, results of operations and cash flows of the Company. If the Company is unable to generate sufficient cash flow from its operations or successfully negotiate debt or lease amendments, the Company may have to explore a variety of other options, including but not limited to other sources of equity or debt financings, asset dispositions, or relief under the United States Bankruptcy Code. The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset carrying amounts or the amounts and classification of liabilities that might result should the Company be unable to continue as a going concern. The independent public accountant's report on the Company's financial statements at December 31, 2001 included a paragraph with regards to the uncertainties of the Company's ability to continue as a going concern. 3. INSURANCE MATTERS The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence in providing care to its patients - the Company is no exception in this regard. As a result, the Company has numerous liability claims and disputes outstanding for professional liability and other related issues. On June 22, 2001, a jury in Mena, Arkansas issued a verdict in a professional liability lawsuit against the Company totaling $78.425 million. The Company has appealed this verdict. The Company and its subsidiaries carry professional liability insurance up to certain limits for coverage of such claims. However, due to the increasing cost of claims against the Company and throughout the long-term care industry, the Company's professional liability insurance premiums and deductible amounts increased substantially and coverage limits have decreased substantially during 1999, 2000 and 2001. These substantial premium and deductible increases have also continued for the policy year 2002. As a result of the substantial premium and deductible increases and insurance coverage decreases for the 2002 policy year, effective March 9, 2002, the Company has obtained professional liability insurance coverage for its United States nursing homes and assisted living facilities that could be substantially less than the claims that could be incurred during the policy period from March 9, 2002 through March 9, 2003. For claims made after March 9, 2002, the 10 Company maintains general and professional liability insurance with coverage limits of $250,000 per medical incident and total aggregate policy coverage limits of $1,000,000 for its long-term care and assisted living services. The Company provides reserves on an actuarial basis for known and expected claims incurred during the policy period. The 2002 policy is on a claims made basis and the Company is self-insured for the first $25,000 per occurrence. For claims made during the period March 9, 2001 through March 9, 2002, the Company is self-insured for the first $50,000 per occurrence with no aggregate limit for the Company's United States nursing homes. The policy has coverage limits of $2,000,000 per occurrence and $3,000,000 in the aggregate. The Company provides reserves on an actuarial basis for known and expected claims incurred during the policy period. This policy is on a claims made basis. Effective October 1, 2001, the Company's United States assisted living properties were added to the Company's insurance program for United States nursing home properties. For claims made during the period March 9, 2000 through March 9, 2001, the Company is self-insured for the first $500,000 per occurrence with no aggregate limit for the Company's United States nursing homes. The policy has coverage limits of $1,000,000 per occurrence, $3,000,000 per location and $12,000,00 in the aggregate. The Company also maintains umbrella coverage of $15,000,000 in the aggregate for claims made during the period March 9, 2000 through March 9, 2001. The Company provides reserves on an actuarial basis for known and expected claims incurred during the policy period. This policy is on a claims made basis. Prior to March 9, 2000, all of these policies are on an occurrence basis. For the policy periods January 1, 1998 through February 1, 1999, the Company is self-insured for the first $250,000 per occurrence and $2,500,000 in the aggregate per year with respect to the majority of its United States nursing homes. Effective February 1, 1999, all United States nursing homes became part of the $250,000/$2,500,000 deductible program, including the six Texas facilities that were owned by a limited partnership of which the Company was the general partner. For the policy years 1996 through March 9, 2000, the Company expects to ultimately fully incur the aggregate deductible amount and has established reserves based on this expectation. The Company's United States assisted living facilities are self-insured, with respect to each location, for the first $50,000 per occurrence through September 30, 2001. Effective October 1, 2001, the Company's United States assisted living properties were added to the Company's insurance program for United States nursing home properties. The Company also maintains a $15,000,000 aggregate umbrella liability policy for claims in excess of the foregoing limits for these assisted living operations through September 30, 2001. 11 In Canada, the Company's professional liability claims experience and associated costs has been dramatically less than that in the United States. The Canadian facilities owned or leased by the Company are self-insured for the first $3,000 ($5,000 Canadian) per occurrence. The Company's aggregate primary coverage limit with respect to Canadian operations is $1,257,000 ($2,000,000 Canadian). The Company also maintains a $3,143,000 ($5,000,000 Canadian) aggregate umbrella policy for claims in excess of the foregoing limits for these facilities. The Company has recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $24,821,000 as of March 31, 2002. Such liabilities include estimates of legal costs. The Company believes that the $78.425 million monetary judgment, if upheld by the Arkansas Supreme Court (to which the judgment is currently under appeal), will be covered by insurance pursuant to the 1997 and 1998 insurance programs. Based on the expected insurance coverage, the judgment amount has not been accrued. The ultimate results of the Company's professional liability claims and disputes are unknown at the present time. In addition, the payment of professional liability claims by the Company's insurance carriers is dependent upon the financial solvency of the individual carriers. The Company is aware that two of its insurance carriers providing coverage for prior years claims have either been declared insolvent or are currently under rehabilitation proceedings. Any future judgments or settlements above the Company's per occurrence, per location or umbrella coverage or not covered by insurance due to the insolvency of the insurance carrier could have a material adverse impact on the Company's financial position, cash flows and results of operations. In addition, the ultimate payment of professional liability claims accrued as of March 31, 2002 and claims that could be incurred during 2002 could require cash resources during 2002 that would be in excess of the Company's available cash or other resources. These potential future payments could have a material adverse impact on the Company's financial position and cash flows. 4. OTHER COMPREHENSIVE INCOME The Company follows the provisions of Statement of Financial Accounting Standards ("SFAS") No. 130, Reporting Comprehensive Income. SFAS No. 130 requires the reporting of comprehensive income in addition to net income from operations. Comprehensive income is a more inclusive financial reporting methodology that includes disclosure of certain financial information that historically has not been recognized in the calculation of net income. Information with respect to the accumulated other comprehensive income balance is presented below:
THREE MONTHS ENDED MARCH 31, --------------------------------- 2002 2001 --------- --------- Foreign currency items: Beginning balance $(935,000) $ (448,000) Current-period change, net of income tax (60,000) (427,000) --------- --------- Ending balance $(995,000) $(875,000) ========= =========
Positive amounts represent unrealized gains and negative amounts represent unrealized losses. 12 5. OPERATING SEGMENT INFORMATION The Company has three reportable segments: U.S. nursing homes, U.S. assisted living facilities, and Canadian operations, which consists of both nursing home and assisted living services. Management evaluates each of these segments independently due to the geographic, reimbursement, marketing, and regulatory differences between the segments. Management evaluates performance based on profit or loss from operations before income taxes not including nonrecurring gains and losses and foreign exchange gains and losses. The following information is derived from the Company's segments' internal financial statements and includes information related to the Company's unallocated corporate revenues and expenses:
THREE MONTHS ENDED MARCH 31, --------------------------- (IN THOUSANDS) 2002 2001 -------- -------- Net revenues: U.S. nursing homes 39,853 $ 37,658 U.S. assisted living facilities 7,830 8,099 Canadian operations 3,889 3,929 Corporate 2 3 -------- -------- Total $ 51,574 $ 49,689 ======== ======== Depreciation and amortization: U.S. nursing homes 827 $ 874 U.S. assisted living facilities 419 424 Canadian operations 120 95 Corporate 17 18 -------- -------- Total $ 1,383 $ 1,411 ======== ======== Operating income (loss): U.S. nursing homes (2,104) $ (997) U.S. assisted living facilities (492) 4 Canadian operations 412 422 Corporate (784) (812) -------- -------- Total $ (2,968) $ (1,383) ======== ========
13
MARCH 31, DECEMBER 31, 2002 2001 --------- ------------ Long-lived assets: U.S. nursing homes 26,447 $ 26,807 U.S. assisted living facilities 29,334 29,760 Canadian operations 12,606 12,016 Corporate 710 707 -------- -------- Total $ 69,097 $ 69,290 ======== ======== Total assets: U.S. nursing homes 52,117 $53,665 U.S. assisted living facilities 30,539 30,912 Canadian operations 17,283 17,183 Corporate 1,399 1,415 Eliminations (14,474) (12,105) -------- -------- Total $ 86,864 $ 91,070 ======== ========
6. RECLASSIFICATIONS Certain amounts in the 2001 interim financial statements have been reclassified to conform with the 2002 presentation. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Advocat Inc. (together with its subsidiaries, "Advocat" or the "Company") provides long-term care services to nursing home patients and residents of assisted living facilities in 12 states, primarily in the Southeast, and four Canadian provinces. The Company's facilities provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care facilities, the Company offers a variety of comprehensive rehabilitation services as well as medical supply and nutritional support services. The Company completed its initial public offering in May 1994; however, its operational history can be traced to February 1980 through common senior management who were involved in different organizational structures. As of March 31, 2002, the Company operates 116 facilities, consisting of 62 nursing homes with 6,992 licensed beds and 54 assisted living facilities with 5,354 units. In comparison, at March 31, 2001, the Company operated 120 facilities composed of 64 nursing homes containing 7,230 licensed beds and 56 assisted living facilities containing 5,245 units. As of March 31, 2002, the Company owns 13 nursing homes, leases 34 others and manages the remaining 15 nursing homes. Additionally, the Company owns 16 assisted living facilities, leases 24 others and manages the remaining 14 assisted living facilities. The Company holds a minority interest in seven of these managed assisted living facilities. The Company operates 49 nursing homes and 32 assisted living facilities in the United States and 13 nursing homes and 22 assisted living facilities in Canada. In March 2002, the Company entered into a letter of intent with Pierce Management Group and related persons (collectively, "Pierce"), pursuant to which the 13 leases with the former principal owners or affiliates of Pierce will be terminated and leases on two additional assisted living facilities will be assumed by Pierce, each with an effective date to be determined upon satisfactory negotiation of a Lease Termination and Operations Transfer Agreement (the "Pierce Agreement"). Effective April 30, 2002, the Company completed the Pierce Agreement 14 with respect to the 13 facilities leased from the former principal owners or affiliates of Pierce. As a result, the Company was relieved of its future obligations with respect to these 13 leases. The Company will incur a write-down in the second quarter of 2002 of the remaining net book value of these facilities, estimated to be approximately $800,000. The leases on the two additional assisted living facilities will be similarly terminated, with an effective date to be determined upon satisfactory transfer of the licenses of these facilities. It is expected that this transfer will occur effective June 1. Basis of Financial Statements. The Company's patient and resident revenues consist of the fees charged for the care of patients in the nursing homes and residents of the assisted living facilities owned and leased by the Company. Management fee revenues consist of the fees charged to the owners of the facilities managed by the Company. The management fee revenues are based on the respective contractual terms of the Company's management agreements, which generally provide for management fees ranging from 3.5% to 6.0% of the net revenues of the managed facilities. As a result, the level of management fees is affected positively or negatively by the increase or decrease in the average occupancy level rates of the managed facilities. The Company's operating expenses include the costs, other than lease, depreciation and amortization expenses, incurred in the operation of the nursing homes and assisted living facilities owned and leased by the Company. The Company's general and administrative expenses consist of the costs of the corporate office and regional support functions, including the costs incurred in providing management services to other owners. The Company's depreciation, amortization and interest expenses include all such expenses across the range of the Company's operations. CRITICAL ACCOUNTING POLICIES AND JUDGMENTS The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. In December 2001, the Securities and Exchange Commission ("SEC") requested that all registrants list their three to five critical accounting policies in the text of "Managements Discussion and Analysis of Financial Condition and Results of Operations." The SEC indicated that a "critical accounting policy" is one which is both important to the understanding of the financial condition and results of operations of the Company and requires management's most difficult, subjective or complex judgments often of the need to make estimates about the effect of matters that are inherently uncertain. The following accounting policies fit this definition: Revenues PATIENT AND RESIDENT REVENUES The fees charged by the Company to patients in its nursing homes and residents in its assisted living facilities include fees with respect to individuals receiving benefits under 15 federal and state-funded cost reimbursement programs. These revenues are based on approved rates for each facility that are either based on current costs with retroactive settlements or prospective rates with no cost settlement. Amounts earned under federal and state programs with respect to nursing home patients are subject to review by the third-party payors. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. Final cost settlements, if any, are recorded when objectively determinable, generally within three years of the close of a reimbursement year depending upon the timing of appeals and third-party settlement reviews or audits. MANAGEMENT FEES Under its management agreements, the Company has responsibility for the day-to-day operation and management of each of its managed facilities. The Company typically receives a base management fee ranging generally from 3.5% to 6.0% of net revenues of each managed facility. Other than certain corporate and regional overhead costs, the services provided at the facility are at the facility owner's expense. The facility owner is also obligated to pay for all required capital expenditures. The Company generally is not required to advance funds to the owner. Other than with respect to facilities managed during insolvency or receivership situations, the Company's management fees are generally subordinated to the debt payments of the facilities it manages. In addition, the Company is generally eligible to receive incentives over and above its base management fees based on the profits at these facilities. ALLOWANCE FOR DOUBTFUL ACCOUNTS The Company's allowance for doubtful accounts is estimated utilizing current agings of accounts receivable, historical collections data and other factors. Management monitors these factors and determines the estimated provision for doubtful accounts. Historical bad debts have resulted from uncollectible private balances, some uncollectible coinsurance and deductibles and other factors. The allowance for doubtful accounts balance is assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Self-Insurance Reserves Self insurance reserves primarily represent the accrual for self insured risks associated with general and professional liability claims, employee health insurance and workers compensation. The self insurance reserves include a liability for reported claims and estimates for incurred but unreported claims. The Company's policy with respect to a significant portion of the general and professional liability claims is to use an actuary to support the estimates recorded for incurred but unreported claims. The Company's health insurance reserve is based on known claims incurred and an estimate of incurred but unreported claims determined by an analysis of historical claims paid. The Company's workers compensation reserve relates to periods of self insurance prior to May 1997 and consists only of known claims incurred. The workers compensation reserve is based on an estimate of the future costs to be incurred for the known claims. Expected insurance coverages are reflected as a reduction of the reserves. The self 16 insurance reserves are assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Asset Impairment In accordance with Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of", the Company evaluates the recoverability of the carrying values of its properties on a property by property basis. On a quarterly basis, the Company reviews its properties for recoverability when events or circumstances, including significant physical changes in the property, significant adverse changes in general economic conditions, and significant deteriorations of the underlying cash flows of the property, indicate that the carrying amount of the property may not be recoverable. The need to recognize an impairment is based on estimated future cash flows from a property compared to the carrying value of that property. If recognition of an impairment is necessary, it is measured as the amount by which the carrying amount of the property exceeds the fair value of the property. MEDICARE REIMBURSEMENT During 1997, the federal government enacted the Balanced Budget Act of 1997 ("BBA"), which contained numerous Medicare and Medicaid cost-saving measures. The BBA required that nursing homes transition to a prospective payment system ("PPS") under the Medicare program during a three-year "transition period," commencing with the first cost reporting period beginning on or after July 1, 1998. The BBA also contained certain measures that have and could lead to further future reductions in Medicare therapy reimbursement and Medicaid payment rates. Revenues and expenses have both been reduced significantly from the levels prior to PPS. The BBA has negatively impacted the entire long-term care industry. During 1999 and 2000, certain amendments to the BBA were enacted, including the Balanced Budget Reform Act of 1999 ("BBRA") and the Benefits Improvement and Protection Act of 2000 ("BIPA"). The BBRA has provided legislative relief in the form of increases in certain Medicare payment rates during 2000. The BIPA has continued to provide additional increases in certain Medicare payment rates during 2001. In July 2001 CMS published a final rule updating payment rates for skilled nursing facilities under PPS. The new rules increased payments to skilled nursing facilities by an average of 10.3% beginning on October 1, 2001. Although refinements resulting from the BBRA and the BIPA have been well received by the United States nursing home industry, it is the Company's belief that the resulting revenue enhancements are still significantly less than the losses sustained by the industry due to the 17 BBA. Current levels of or further reductions in government spending for long-term health care would continue to have an adverse effect on the operating results and cash flows of the Company. The Company will attempt to maximize the revenues available from governmental sources within the changes that have occurred and will continue to occur under the BBA. In addition, the Company will attempt to increase revenues from non-governmental sources, including expansion of its assisted living operations, to the extent capital is available to do so, if at all. Under the current law, Medicare reimbursements for nursing facilities were scheduled to be reduced by as much as 17% at the end of the Federal Government's fiscal year (September 30, 2002), with the expiration of several temporary payment increases enacted as part of the 1999 and 2000 Medicare enhancement bills. On April 23, 2002, the Health and Human Services Secretary announced that the Centers for Medicare & and Medicaid would leave in place the current prospective payment patient classification system for skilled nursing facilities, reducing the scheduled Medicare reductions by approximately one-half. Two other temporary payment increases are still scheduled to expire October 1, 2002. The Company has estimated that the revenue reduction as a result of the expiration of the temporary impact would be at least $3.8 million, based on the Medicare census and patient RUG levels experienced by the Company in 2001. The actual impact can not be determined at this time and is dependent on the changes that are legislatively implemented and on the Company's Medicare census and patient RUG levels. During 1999, 2000 and 2001, the Company experienced certain adverse regulatory issues with respect to certain facilities, including a decertification from the Medicare and Medicaid programs during 2000. The Company also continued to experience the increased regulatory scrutiny that has been exerted on the industry in the form of increased fines and penalties. SELF-INSURANCE RESERVES The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence in providing care to its patients - the Company is no exception in this regard. As a result, the Company has numerous liability claims and disputes outstanding for professional liability and other related issues. On June 22, 2001, a jury in Mena, Arkansas issued a verdict in a professional liability lawsuit against the Company totaling $78.425 million. The Company has appealed the verdict. The Company and its subsidiaries carry professional liability insurance up to certain limits for coverage of such claims. However, the insurance coverage limits available to the Company has declined significantly beginning in 1999. Based on the insurance coverage in effect at the time of the Mena claim, the verdict amount has not been accrued. However, due to the increasing cost of claims against the both Company and throughout the long-term care profession in general, the Company's professional liability insurance premiums and deductible amounts increased substantially and insurance coverage limits decreased substantially during 1999, 2000 and 2001. These substantial premium and deductible increases and insurance coverage limit decreases have also continued for the policy year 2002. As a result of the substantial premium and deductible increases and insurance coverage limit decreases for the 2002 policy year, effective March 9, 2002, the Company has obtained professional liability insurance coverage for its 18 United States nursing homes and assisted living facilities that is likely to be substantially less than the claims that could be incurred during the policy period from March 9, 2002 through March 9, 2003. As a result, the Company is effectively self-insured. For claims made after March 9, 2002, the Company maintains general and professional liability insurance with coverage limits of $250,000 per medical incident and total aggregate policy coverage limits of $1,000,000 for its long-term care and assisted living services. The Company provides reserves on an actuarial basis for known and expected claims incurred during the policy period. The 2002 policy is on a claims made basis and the Company is self-insured for the first $25,000 per occurrence. For claims made during the period March 9, 2001 through March 9, 2002, the Company is self-insured for the first $50,000 per occurrence with no aggregate limit for the Company's United States nursing homes. The policy has coverage limits of $2,000,000 per occurrence and $3,000,000 in the aggregate. The Company provides reserves on an actuarial basis for known and expected claims incurred during the policy period. This policy is on a claims made basis. Effective October 1, 2001, the Company's United States assisted living properties were added to the Company's insurance program for United States nursing home properties. For claims made during the period March 9, 2000 through March 9, 2001, the Company is self-insured for the first $500,000 per occurrence with no aggregate limit for the Company's United States nursing homes. The policy has coverage limits of $1,000,000 per occurrence, $3,000,000 per location and $12,000,00 in the aggregate. The Company also maintains umbrella coverage of $15,000,000 in the aggregate for claims made during the period March 9, 2000 through March 9, 2001. The Company provides reserves on an actuarial basis for known and expected claims incurred during the policy period. This policy is on a claims made basis. Prior to March 9, 2000, all of these policies are on an occurrence basis. For the policy periods January 1, 1998 through February 1, 1999, the Company is self-insured for the first $250,000 per occurrence and $2,500,000 in the aggregate per year with respect to the majority of its United States nursing homes. Effective February 1, 1999, all United States nursing homes became part of the $250,000/$2,500,000 deductible program, including the six TDLP facilities. For the policy years 2000 and 1999, the Company expects to ultimately fully incur the aggregate deductible amount and has established reserves based on this expectation. The Company's United States assisted living facilities are self-insured, with respect to each location, for the first $50,000 per occurrence through September 2001. Effective October 1, 2001, the Company's United States assisted living properties were added to the Company's insurance program for United States nursing home properties. The Company also maintains a $15,000,000 aggregate umbrella liability policy for claims in excess of the foregoing limits for these assisted living operations. In Canada, the Company's professional liability claims experience and associated costs has been dramatically less than that in the United States. The Canadian facilities owned or leased by the Company are self-insured for the first $3,000 ($5,000 Canadian) per occurrence. The Company's aggregate primary coverage limit with respect to Canadian operations is $1,257,000 19 ($2,000,000 Canadian). The Company also maintains a $3,143,000 ($5,000,000 Canadian) aggregate umbrella policy for claims in excess of the foregoing limits for these facilities. The Company has recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $24,821,000 as of March 31, 2002. Such liabilities include estimates of legal costs. The Company believes that the $78.425 million monetary judgment, if upheld by the Arkansas State Supreme Court, will be covered by insurance pursuant to the 1997 and 1998 insurance programs. Based on the insurance coverage in effect at the time of the Mena claim, the verdict amount has not been accrued. The ultimate results of the Company's professional liability claims and disputes are unknown at the present time. In addition, the payment of professional liability claims by the Company's insurance carriers is dependent upon the financial solvency of the individual carriers. The Company is aware that two of its insurance carriers providing coverage for prior years claims have either been declared insolvent or are currently under rehabilitation proceedings. Any future judgments or settlements above the Company's per occurrence, per location or umbrella coverage or not covered by insurance due to the insolvency of the insurance carrier could have a material adverse impact on the Company's financial position, cash flows and results of operations. In addition, the ultimate payment of professional liability claims accrued as of March 31, 2002 and claims that could be incurred during 2002 could require cash resources during 2002 that would be in excess of the Company's available cash or other resources. These potential future payments could have a material adverse impact on the Company's financial position and cash flows. With respect to workers' compensation insurance, substantially all of the Company's employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. Prior to that time, the Company was self-insured for the first $250,000, on a per claim basis, for workers' compensation claims in a majority of its United States nursing facilities. However, the insurance carrier providing coverage above the Company's self insured retention has been declared insolvent by the applicable state insurance agency. As a result, the Company is completely self insured for workers compensation exposures prior to May 1997. The Company has been and remains a non-subscriber to the Texas workers' compensation system and is, therefore, completely self-insured for employee injuries with respect to its Texas operations. The Company has provided reserves for the settlement of outstanding self-insured claims at amounts believed to be adequate as of March 31, 2002. The differences between actual settlements and reserves are included in expense in the year finalized. The Company is self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 per individual annually. The Company provides reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate. The liability for reported claims and estimates for incurred but unreported claims is $787,000 at March 31, 2002. The differences between actual settlements and reserves are included in expense in the year finalized. 20 HEALTH CARE INDUSTRY The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse (collectively, the "Health Care Laws"). Changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, could have a material adverse effect on the Company's financial position, results of operations, and cash flows. Future federal budget legislation and federal and state regulatory changes may negatively impact the Company. All of the Company's facilities are required to obtain annual licensure renewal and are subject to annual surveys and inspections in order to be certified for participation in the Medicare and Medicaid programs. In order to maintain their state operating license and their certification for participation in Medicare and Medicaid programs, the nursing facilities must meet certain statutory and administrative requirements. These requirements relate to the condition of the facilities, the adequacy and condition of the equipment used therein, the quality and adequacy of personnel, and the quality of resident care. Such requirements are subjective and subject to change. There can be no assurance that, in the future, the Company will be able to maintain such licenses for its facilities or that the Company will not be required to expend significant sums in order to do so. Recently, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse statutes and regulations. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations can be subject to future government review and interpretation as well as regulatory actions unknown or unasserted at this time. The Company is currently a defendant in two pending false claims actions as described below. On October 17, 2000, the Company was served with a civil complaint by the Florida Attorney General's office, in the case of State of Florida ex rel. Mindy Myers v. R. Brent Maggio, et al. In this case, the State of Florida has accused multiple defendants of violating Florida's False Claims Act. The Company, in its capacity as the manager of four nursing homes owned by Emerald Coast Healthcare, Inc. ("Emerald"), was named in the complaint, as amended, which accused the Company of making illegal kickback payments to R. Brent Maggio, Emerald's sole shareholder, and fraudulently concealing such payments in the Medicaid cost reports filed by the nursing homes. At a hearing held April 25, 2001 in the Circuit Court of Leon County, Florida, the Court dismissed the State of Florida's complaint in its entirety based on the State's failure to plead false claims violations with sufficient particularity as required by law. On October 15, 2001, the State of Florida filed a second amended complaint against the same defendants. The second amended complaint also accused the Company of (i) receiving payment by mistake of fact, (ii) unjust enrichment and (iii) civil theft. At a hearing held January 31, 21 2002, the court granted the Company's motion to dismiss the false claims count based on the State's failure to state a cause of action, but did not grant motions to dismiss the equitable counts of unjust enrichment and payment by mistake, or the civil theft claim. The Company is appealing the judge's decision. The Court ruling allowed the State of Florida to file a third amended complaint, which was filed on March 11, 2002. The Company has filed a motion to dismiss, with prejudice, the State's complaint. A hearing is scheduled for May 24, 2002 on this motion. The Company believes that it has meritorious defenses in this case, and intends to vigorously pursue these defenses in litigation. Under the Federal False Claims Act, health care companies may be named as a defendant in an action which is filed under court seal, without being informed of this fact until the government has substantially completed its investigation. In such cases, there sometimes occurs a provision for "partial lifting of the seal," in which the trial court orders that the seal may be lifted for purposes of giving the named defendant the opportunity to informally present its defenses and discuss settlement prospects with the government. In cases in which the judge orders such a "partial lifting of the seal," the defendant becomes aware of the case but is precluded from discussing it publicly. The one case to which the Company had referred in previous filings was U.S.A ex rel. Susan Elaine Connor and Cathy L. Johnson v. Cambridge Medical Center a/k/a Mayfield Rehabilitation & Special Care Center a/k/a Diversicare Leasing Corp. USDC, Middle District of Tennessee, No. 3:98-0605. In November 2001, the court entered an order indicating that the Department of Justice had chosen not to intervene in this case. The Company does not know whether the individual relators will pursue this action, but the Company plans to vigorously defend the case if it does proceed. While the Company cannot currently predict with certainty the ultimate impact of either of the above cases on the Company's financial condition, cash flows or results of operations, an unfavorable outcome in any state or federal False Claims Act case could subject the Company to fines, penalties and damages. Moreover, the Company could be excluded from the Medicare, Medicaid or other federally-funded health care programs, which could have a material adverse impact on the Company's financial condition, cash flows or results of operations. During 2000 and 2001, the Company also experienced the increased regulatory scrutiny that has been exerted on the industry in the form of increased fines and penalties. During 2000, one of the Company's facilities in Texas was decertified from the Medicaid and Medicare programs. 22 CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS The Company has certain contractual obligations as of March 31, 2002, summarized by the period in which payment is due, as follows (dollar amounts in thousands):
---------------------------------------------------------------------------------------------------------------- LESS THAN 1 1 TO 3 4 TO 5 AFTER CONTRACTUAL OBLIGATIONS TOTAL YEAR YEARS YEARS 5 YEARS ---------------------------------------------------------------------------------------------------------------- Debt $60,047 $33,771 $10,844 $9,141 $6,291 ---------------------------------------------------------------------------------------------------------------- Operating Leases $400,671 $19,280 $38,606 $37,705 $305,080 ----------------------------------------------------------------------------------------------------------------
In March 2002, the Company entered into a letter of intent with Pierce, pursuant to which the 13 leases with the former principal owners or affiliates of Pierce will be terminated and leases on two additional assisted living facilities will be assumed by Pierce, each with an effective date to be determined upon satisfactory negotiation of the Pierce Agreement. Effective April 30, 2002, the Company completed the Pierce Agreement with respect to the 13 facilities leased from the former principal owners or affiliates of Pierce. As a result, the Company was relieved of its future obligations with respect to these 13 leases. The operating lease section of the table above includes commitments of $95.9 million (including $4.2 million commitments less than one year) related to these terminated leases. The leases on the two additional assisted living facilities will be similarly terminated, with an effective date to be determined upon satisfactory transfer of the licenses of these facilities. It is expected that this transfer will occur effective June 1. The operating lease section of the table above includes commitments of $16.8 million (including $0.8 million commitments less than one year) related to these two additional leases, expected to be terminated effective June 1, 2002. The Company has employment agreements with certain members of management that provide for the payment to these members of amounts up to 2.5 times their annual salary in the event of a termination without cause, a constructive discharge (as defined), or upon a change of control of the Company (as defined). The maximum contingent liability under these agreements is approximately $2.5 million. In addition, upon the occurrence of any triggering event, certain executives may elect to require the Company to purchase options granted to them for a purchase price equal to the excess, if any, of the fair market value of the Company's common stock at the date of termination over the stated option exercise price. The terms of such agreements are from one to three years and automatically renew for one year if not terminated by the employee or the Company. A subsidiary of the Company has provided guarantees of certain cash flow deficiencies and quarterly return obligations of Diversicare VI Limited Partnership ("Diversicare VI"), which may obligate the subsidiary to make interest-free loans to Diversicare VI. Such cash flow obligations have never been called upon. There is no assurance that all or any portion of the loans made to Diversicare VI will be repaid. 23 RESULTS OF OPERATIONS The following tables present the unaudited interim statements of operations and related data for the three months ended March 31, 2002 and 2001.
(IN THOUSANDS) THREE MONTHS ENDED MARCH 31, ---------------------------------------------- 2002 2001 CHANGE % -------- -------- ------ --- REVENUES: Patient revenues $ 40,691 $ 38,312 2,379 6.2 Resident revenues 10,179 10,420 (241) (2.3) Management fees 679 911 (232) (25.5) Interest 25 46 (21) (45.7) -------- -------- ----- --- Net revenues 51,574 49,689 1,885 3.8 -------- -------- ----- --- EXPENSES: Operating 43,728 39,735 3,993 10.0 Lease 5,180 5,175 5 0.1 General and administrative 3,159 3,235 (76) (2.3) Interest 1,092 1,516 (424) (28.0) Depreciation and amortization 1,383 1,411 (28) (2.0) -------- -------- ----- --- Total expenses 54,542 51,072 3,470 6.8 -------- -------- ----- --- LOSS BEFORE INCOME TAXES (2,968) (1,383) (1,585) PROVISION FOR INCOME TAXES 93 90 3 -------- -------- ----- NET LOSS $ (3,061) $ (1,473) $(1,588) ======== ======== =======
PERCENTAGE OF NET REVENUES THREE MONTHS ENDED MARCH 31, ---------------------------- 2002 2001 --------- --------- REVENUES: Patient revenues 78.9% 77.1% Resident revenues 19.7 21.0 Management fees 1.3 1.8 Interest 0.1 0.1 ----- ----- Net revenues 100.0% 100.0% ----- ----- OPERATING EXPENSES: Operating 84.8 80.0 Lease 10.0 10.4 General and administrative 6.1 6.5 Interest 2.1 3.1 Depreciation and amortization 2.7 2.8 ----- ----- Total expenses 105.7 102.8 ----- ----- LOSS BEFORE INCOME TAXES (5.7) (2.8) PROVISION FOR INCOME TAXES 0.2 0.2 ----- ----- NET LOSS (5.9)% (3.0)% ----- -----
24 THREE MONTHS ENDED MARCH 31, 2001 COMPARED WITH THREE MONTHS ENDED MARCH 31, 2000 Revenues. Net revenues increased to $51.6 million in 2002 from $49.7 million in 2001, an increase of $1.9 million, or 3.8%. Patient revenues increased to $40.7 million in 2002 from $38.3 million in 2001, an increase of $2.4 million, or 6.2%. The increase in patient revenues is due to increased Medicare utilization, Medicare rate increases at several facilities which became effective in October 2001 and increased Medicaid rates in certain states, partially offset by a 0.6% decline in occupancy in 2002 as compared to 2001. In addition, the Company terminated leases on two nursing homes during the fourth quarter of 2001. As a percent of total census in the United States, Medicare days increased to 9.8% in 2002 from 7.4% in 2001. As a percent of patient revenues, Medicare increased to 24.8% in 2002 from 21.5% in 2001 while Medicaid and similar programs decreased to 63.0% from 65.1% in 2001. Resident revenues decreased to $10.2 million in 2002 from $10.4 million in 2001, a decrease of $200,000, or 2.3%. The Company experienced increased revenue rates, offset by a 6.5% decline in resident days. Ancillary service revenues, prior to contractual allowances, increased to $6.6 million in 2002 from $5.4 million in 2001, as increase of $1.2 million or 23.4%. The increase is primarily attributable to increased Medicare census, partially offset by reductions in revenue availability under Medicare and is consistent with the Company's expectations. Although the $1,500 per patient annual ceiling has now been lifted for a two year period on physical, speech and occupational therapy services, the impact of the relief is not expected to be sufficient to offset the substantial losses that have been incurred by the Company and the long-term care industry from the provision of therapy services. The ultimate effect on the Company's operations cannot be predicted at this time because the extent and composition of the ancillary cost limitations are subject to change. Operating Expense. Operating expense increased to $43.7 million in 2002 from $39.7 million in 2001, an increase of $4.0 million, or 10.0%. As a percent of patient and resident revenues, operating expense increased to 86.0% in 2002 from 81.5% in 2001. The increase as a percent of patient and resident revenues is primarily attributable to cost increases related to wages and professional liability, partially offset by a reduction in costs as a result of the termination of leases on two nursing homes effective during the fourth quarter of 2001. The largest component of operating expenses is wages, which increased to $22.3 million in 2002 from $21.5 million in 2001, an increase of $0.8 million, or 3.7%. The increase in wages is due to tighter labor markets in most of the areas in which the Company operates, partially offset by the facility lease terminations noted above. The Company's professional liability costs for United States nursing homes, including insurance premiums and reserves for self-insured claims, increased to $4.8 million in 2001 from $2.0 million in 2001, an increase of $2.8 million or 136.3%. The 2002 professional liability cost includes non-cash charges recorded based on current actuarial reviews, including the recent effects of additional claims and higher settlements per claim. The increased charges arise primarily from an escalation in the number and size of claims anticipated to affect the Company's self-insured professional liability retention. In addition, effective March 9, 2001, the Company obtained professional liability insurance coverage that provided significantly lower benefits than prior policy years. During 2001, the Company determined that two of its insurance carriers providing coverage for prior rehabilitation years claims have either been declared insolvent or are currently under 25 proceedings. The actuarial review included estimates of known claims and a prediction of claims that may have occurred, but have not yet been reported to the Company. Lease Expense. Lease expense totaled $5.2 million in both 2002 and 2001. General and Administrative Expense. General and administrative expense totaled $3.2 million in both 2002 and 2001. As a percent of total net revenues, general and administrative expense decreased to 6.1% in 2002 from 6.5% in 2001. Increases in various corporate expenses, including salaries and wages and workers compensation were offset by decreases in employee recruitment and relocation and consulting fees. The 2001 period included a provision for severance benefits for the former Chief Financial Officer of the Company. Interest Expense. Interest expense decreased to $1.1 million in 2002 from $1.5 million in 2001, a decrease of $424,000, or 28.0%. The decrease is attributable to interest rate reductions on the Company's variable rate debt and a decrease in 2002 in the Company's average outstanding debt balance. Depreciation and Amortization. Depreciation and amortization expenses totaled $1.4 million in both 2002 and 2001. Loss Before Income Taxes; Net Loss; Loss Per Share. As a result of the above, the loss before income taxes was $3.0 million in 2002 as compared to $1.4 million in 2001, a decrease of $1.6 million. The income tax provision in 2002 and 2001 relate to provincial taxes in Canada. Net loss was $3.1 million in 2002 as compared to $1.5 million in 2001, a decrease of $1.6 million. The basic and diluted loss per share were $0.56 each in 2002 as compared to $0.27 each in 2001. LIQUIDITY AND CAPITAL RESOURCES At March 31, 2002, the Company had negative working capital of $61.5 million and a current ratio of 0.22, compared with negative working capital of $64.4 million and a current ratio of 0.25 at December 31, 2001. The Company has incurred losses during 2002, 2001 and 2000 and has limited resources available to meet its operating, capital expenditure and debt service requirements during 2002. Certain of the Company's debt agreements contain various financial covenants, the most restrictive of which relate to current ratio requirements, tangible net worth, cash flow, net income (loss), required insurance coverages, and limits on the payment of dividends to shareholders. As of March 31, 2002, the Company was not in compliance with certain of the financial covenants contained in the Company's debt and lease agreements. The Company has not obtained waivers of the non-compliance. Cross-default or material adverse change provisions contained in the debt agreements allow the holders of substantially all of the Company's debt to demand immediate repayment. The Company would not be able to repay this indebtedness if the applicable lenders demanded repayment. Although the Company does not anticipate that such demand will be made, the continued forbearance on the part of the Company's lenders cannot be assured at this time. Given that events of default exist under the 26 Company's working capital line of credit, there can be no assurance that the lender will continue to provide working capital advances. Based on regularly scheduled debt service requirements, the Company has a total of $33.7 million of debt (including short term debt and current portions of long term debt) that must be repaid or refinanced during the next twelve months. As a result of the covenant non-compliance and other cross-default provisions, the Company has classified a total of $55.5 million of debt as current liabilities as of March 31, 2002. An event of default under the Company's debt agreements could lead to actions by the lenders that could result in an event of default under the Company's lease agreements covering a majority of its United States nursing facilities. Should such a default occur in the related lease agreements, the lessor would have the right to terminate the lease agreements and assume operating rights with respect to the leased properties. The net book value of property and equipment, including leasehold improvements, related to these facilities total approximately $4.8 million as of March 31, 2002. The Company is potentially subject to a reduction in Medicare revenue, estimated to be at least $3.8 million, based on the Medicare census and patient RUG levels experienced by the Company in 2001. Management continues to focus on efforts to increase revenues and to minimize future expense increases through the elimination of excess operating costs. Management will also attempt to minimize professional liability claims in the future periods by vigorously defending it against all such claims and through the additional supervision and training of staff employees. The Company is unable to predict if it will be successful in reducing operating losses, in negotiating waivers, amendments, or refinancings of outstanding debt, or if the Company will be able to meet any amended financial covenants in the future. Any demands for repayment by lenders, the inability to obtain waivers or refinance the related debt, or the termination of the lease agreements would have a material adverse impact on the financial position, results of operations and cash flows of the Company. If the Company is unable to generate sufficient cash flow from its operations or successfully negotiate debt or lease amendments, the Company may have to explore a variety of other options, including but not limited to other sources of equity or debt financings, asset dispositions, or relief under the United States Bankruptcy Code. The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset carrying amounts or the amounts and classification of liabilities that might result should the Company be unable to continue as a going concern. The independent public accountant's report on the Company's financial statements at December 31, 2001 included a paragraph with regards to the uncertainties of the Company's ability to continue as a going concern. As of March 31, 2002, the Company had drawn $55,000 under its working capital line of credit. The total maximum outstanding balance of the working capital line of credit, including letters of credit outstanding, is $4,500,000. Of the total $4,500,000 of maximum availability, $1,000,000 is limited to certain maximum time period restrictions. There are certain additional restrictions based on certain borrowing base restrictions. As of March 31, 2002, the Company had $200,000 of letters of credit outstanding with the same bank lender, which further reduce the maximum available amount outstanding under the working capital line of credit. As of March 31, 2002, the Company had total additional borrowing availability of $4,245,000 under 27 its working capital line of credit. The working capital line of credit matures January 2004 with interest at either LIBOR plus 2.50% or the bank's prime rate plus .50% (up to a maximum of 9.50%). Effective March 9, 2001, the Company has obtained professional liability insurance coverage that, based on historical claims experience, could be substantially less than the claims that could be incurred during 2001 and 2002 and is less than the coverage required by certain of the Company's debt and lease agreements. The ultimate payments on professional liability claims accrued as of March 31, 2002 and claims that could be incurred during 2002 could require cash resources during 2002 that would be in excess of the Company's available cash or other resources. Any future operating losses, demands for repayment by lenders, failure to refinance debt maturing during 2002, payments of professional liability claims judgments in excess of insurance coverage or significant reductions in Medicare reimbursement would have a material adverse impact on the financial position, results of operations and cash flows of the Company. If the Company is unable to generate sufficient cash flows from its operations, unable to refinance or repay debt maturities during 2002, or unable to minimize the amount of future professional liability claims payments, it will explore a variety of other options, including but not limited to other sources of equity or debt financing, asset dispositions, or relief under the United States Bankruptcy code. Net cash provided by operating activities totaled $3.4 million and $2.4 million for the three month periods ended March 31, 2002 and 2001, respectively. These amounts primarily represent the cash flows from net operations plus changes in non-cash components of operations and by working capital changes. Net cash used in investing activities totaled $1,311,000 and $776,000 for the three months periods ended March 31, 2002 and 2001, respectively. These amounts primarily represent purchases of property plant and equipment (including approximately $670,000 related to an addition to one of the Company's facilities in Canada), investments in and advances to joint ventures and, with respect to 2001 only, additional investments in TDLP, a limited partnership for which the Company served as the general partner. The Company has used between $2.4 million and $4.4 million for capital expenditures in the three calendar years ending December 31, 2001. Substantially all such expenditures were for facility improvements and equipment, which were financed principally through working capital. For the year ended December 31, 2002, the Company anticipates that capital expenditures for improvements and equipment for its existing facility operations will be approximately $4.0 million, including $1.0 million for non-routine projects. For the three months ended March 31, 2002 and 2001, the Company received funds pertaining to joint ventures in the amount of $22,000 and $269,000, respectively. In general, the Company has been appointed as manager of the joint venture projects. 28 Net cash used in financing activities totaled $3.3 million and $4.6 million for the three month periods ended March 31, 2002 and 2001, respectively. The net cash used in financing activities primarily represents net proceeds from issuance and repayment of debt. RECEIVABLES The Company's operations could be adversely affected if it experiences significant delays in reimbursement of its labor and other costs from Medicare, Medicaid and other third-party revenue sources. The Company's future liquidity will continue to be dependent upon the relative amounts of current assets (principally cash, accounts receivable and inventories) and current liabilities (principally accounts payable and accrued expenses). In that regard, accounts receivable can have a significant impact on the Company's liquidity. Continued efforts by governmental and third-party payors to contain or reduce the acceleration of costs by monitoring reimbursement rates, by increasing medical review of bills for services, or by negotiating reduced contract rates, as well as any delay by the Company in the processing of its invoices, could adversely affect the Company's liquidity and results of operations. Accounts receivable attributable to the provision of patient and resident services at March 31, 2002 and December 31, 2001, totaled $18.9 million and $20.5 million, respectively, representing approximately 33 and 37 days in accounts receivable, respectively. Accounts receivable from the provision of management services were $726,000 and $578,000 at March 31, 2002 and December 31, 2001, respectively representing approximately 96 and 71 days in accounts receivable, respectively. The allowance for bad debt was $5.8 million and $5.5 million as of March 31, 2002 and December 31, 2001, respectively. The Company continually evaluates the adequacy of its bad debt reserves based on patient mix trends, agings of older balances, payment terms and delays with regard to third-party payors, collateral and deposit resources, as well as other factors. The Company continues to evaluate and implement additional procedures in an effort to strengthen its collection efforts and reduce the incidence of uncollectible accounts. FOREIGN CURRENCY TRANSLATION The Company has obtained its financing primarily in U.S. dollars; however, it incurs revenues and expenses in Canadian dollars with respect to Canadian management activities and operations of the Company's eight Canadian retirement facilities (three of which are owned) and two owned Canadian nursing homes. Although not material to the Company as a whole, if the currency exchange rate fluctuates, the Company may experience currency translation gains and losses with respect to the operations of these activities and the capital resources dedicated to their support. While such currency exchange rate fluctuations have not been material to the Company in the past, there can be no assurance that the Company will not be adversely affected by shifts in the currency exchange rates in the future. 29 STOCK EXCHANGE On November 10, 1999, the Company's stock began being quoted on the NASD's OTC Bulletin Board under the symbol AVCA. Previously, the Company's common stock was traded on the New York Stock Exchange under the symbol AVC. INFLATION Management does not believe that the Company's operations have been materially affected by inflation. The Company expects salary and wage increases for its skilled staff to continue to be higher than average salary and wage increases, as is common in the health care industry. To date, these increases as well as normal inflationary increases in other operating expenses have been adequately covered by revenue increases. RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after September 30, 2001. SFAS No. 141 also specifies criteria which intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired outside of a business combination and the accounting for goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 requires that intangible assets with finite useful lives be amortized, and that goodwill and intangible assets with indefinite lives no longer be amortized, but instead tested for impairment at least annually. SFAS No. 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." Furthermore, any goodwill and any intangible asset determined to have an indefinite useful life that are acquired in a purchase business combination completed after June 30, 2001 will not be amortized, but will continue to be evaluated for impairment in accordance with the appropriate pre-SFAS No. 142 accounting literature. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 will continue to be amortized until the adoption of SFAS No. 142. The Company has adopted the provisions of SFAS No. 141 and the adoption did not have a material effect on the Company's financial position or results of operations. The Company has adopted the provisions of SFAS No. 142 as of January 1, 2002 and the adoption did not have a material effect on the Company's financial position or results of operations. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations" effective for fiscal years beginning after June 15, 2002. SFAS 143 requires that a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable 30 estimate of fair value can be made. The Company does not expect the future adoption of SFAS 143 to have a material effect on its financial position or results of operations. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" effective for fiscal years beginning after December 15, 2001. SFAS No. 144 establishes a single accounting model for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and broadens the presentation of discontinued operations to include more disposal transactions. The Company has adopted the provisions of SFAS No. 144 and the adoption did not have a material effect on the Company's financial position or results of operations. FORWARD-LOOKING STATEMENTS The foregoing discussion and analysis provides information deemed by Management to be relevant to an assessment and understanding of the Company's consolidated results of operations and its financial condition. This discussion and analysis should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2001. Certain statements made by or on behalf of the Company, including those contained in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere, are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements involve risks and uncertainties including, but not limited to, changes in governmental reimbursement, government regulation and health care reforms, the increased cost of borrowing under the Company's credit agreements, covenant waivers from the Company's lenders, possible amendments to the Company's credit agreements, ability to control ultimate professional liability costs, the impact of future licensing surveys, changing economic conditions as well as others. Investors also should refer to the risks identified in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" as well as risks identified in the Company's Form 10-K for the year ended December 31, 2001 for a discussion of various risk factors of the Company and that are inherent in the health care industry. Given these risks and uncertainties, the Company can give no assurances that these forward-looking statements will, in fact, transpire and, therefore, cautions investors not to place undue reliance on them. Actual results may differ materially from those described in such forward-looking statements. Such cautionary statements identify important factors that could cause the Company's actual results to materially differ from those projected in forward-looking statements. In addition, the Company disclaims any intent or obligation to update these forward-looking statements. 31 PART II -- OTHER INFORMATION Item 1. Legal Proceedings. The provision of health care services entails an inherent risk of liability. In recent years, participants in the health care industry have become subject to an increasing number of lawsuits alleging malpractice, product liability, or related legal theories, many of which involve large claims and significant defense costs. The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence in providing care to its patients - the Company is no exception in this regard. As a result, the Company has numerous liability claims and disputes outstanding for professional liability and other related issues. It is expected that the Company will continue to be subject to such suits as a result of the nature of its business. Further, as with all health care providers, the Company is potentially subject to the increased scrutiny of regulators for issues related to compliance with health care fraud and abuse laws. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Health Care Industry." Item 3. Defaults Upon Senior Securities. The Company is not currently in compliance with certain covenants of its loan agreements and certain other indebtedness. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." Item 6. Exhibits and Reports on Form 8-K. (a) The exhibits filed as part of the report on Form 10-Q are listed in the Exhibit Index immediately following the signature page. (b) Reports on Form 8-K: On March 22, 2002, the Company filed a Report on Form 8-K announcing that Wallace E. Olson had joined the Company's Board of Directors. 32 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. ADVOCAT INC. May 15, 2002 By: /s/William R. Council, III ----------------------------------------- William R. Council, III Executive Vice-President, Secretary, Principal Financial Officer and Chief Accounting Officer and An Officer Duly Authorized to Sign on Behalf of the Registrant 33 EXHIBIT NUMBER DESCRIPTION OF EXHIBITS ------ ----------------------- 3.1 Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Company's Registration Statement No. 33-76150 on Form S-1). 3.2 Bylaws of the Company (incorporated by reference to Exhibit 3.2 to the Company's Registration Statement No. 33-76150 on Form S-1). 3.3 Amendment to Certificate of Incorporation dated March 23, 1995 (incorporated by reference to Exhibit A of Exhibit 1 to the Company's Form 8-A filed March 30, 1995). 3.4 Certificate of Designation of Registrant (incorporated by reference to Exhibit 3.4 to the Company's quarterly report on Form 10-Q for the quarter ended March 31, 2001). 4.1 Form of Common Stock Certificate (incorporated by reference to Exhibit 4 to the Company's Registration Statement No. 33-76150 on Form S-1). 4.2 Rights Agreement dated March 13, 1995, between the Company and Third National Bank in Nashville (incorporated by reference to Exhibit 1 to the Company's Current Report on Form 8-K dated March 13, 1995). 4.3 Summary of Shareholder Rights Plan adopted March 13, 1995 (incorporated by reference to Exhibit B of Exhibit 1 to Form 8-A filed March 30, 1995). 4.4 Rights Agreement of Advocat Inc. dated March 23, 1995 (incorporated by reference to Exhibit 1 to Form 8-A filed March 30, 1995). 4.5 Amended and Restated Rights Agreement dated as of December 7, 1998 (incorporated by reference to Exhibit 1 to Form 8-A/A filed December 7, 1998). 10.1 Lease Termination and Operations Transfer Agreement dated the 31st day of March, 2002 by and between (i) Diversicare Assisted Living Services NC, LLC, a Tennessee limited liability company and Advocat Inc., a Delaware corporation, and (ii) Pierce Management Group First Partnership, a North Carolina general partnership, Pierce Management Group Fifth Partnership, a North Carolina general partnership, Pierce, Pierce And Hall, a North Carolina general partnership, Guy S. Pierce, individually, A. Steve Pierce and wife Mary Lou Pierce and A. Steve Pierce, individually.