-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, V975PnjETH+L60zsHkpczQYYFouaqZBPkVuWRfaJZqJeW6c22waaP0u9TOQSpDJF OJcw6x2XC6RCUcdXN4MkSg== 0000893220-99-001085.txt : 19990921 0000893220-99-001085.hdr.sgml : 19990921 ACCESSION NUMBER: 0000893220-99-001085 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 19990630 FILED AS OF DATE: 19990920 FILER: COMPANY DATA: COMPANY CONFORMED NAME: NOVACARE INC CENTRAL INDEX KEY: 0000802843 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-MISC HEALTH & ALLIED SERVICES, NEC [8090] IRS NUMBER: 133247827 STATE OF INCORPORATION: DE FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 001-10875 FILM NUMBER: 99713946 BUSINESS ADDRESS: STREET 1: 1016 W NINTH AVE CITY: KING OF PRUSSIA STATE: PA ZIP: 19406 BUSINESS PHONE: 6109927200 MAIL ADDRESS: STREET 1: 1016 WEST NINTH AVENUE CITY: KING OF PRUSSIA STATE: PA ZIP: 19406 FORMER COMPANY: FORMER CONFORMED NAME: INSPEECH INC DATE OF NAME CHANGE: 19891019 10-K405 1 FORM 10-K405 NOVACARE, INC. 1 FORM 10-K SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JUNE 30, 1999 Commission file number 1-10875 NOVACARE, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 13-3247827 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.) 1016 WEST NINTH AVENUE, KING OF PRUSSIA, PA 19406 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICE) (ZIP CODE) Registrant's telephone number, including area code: (610) 992-7200 Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on COMMON STOCK, PAR VALUE $.01 PER SHARE which registered NEW YORK STOCK EXCHANGE, INC. 5 1/2% CONVERTIBLE SUBORDINATED NEW YORK STOCK EXCHANGE, INC. DEBENTURES DUE 2000 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 INDICATE BY CHECK MARK IF DISCLOSURE OF DELINQUENT FILERS PURSUANT TO ITEM 405 OF REGULATION S-K IS NOT CONTAINED HEREIN, AND WILL NOT BE CONTAINED, TO THE BEST OF REGISTRANT'S KNOWLEDGE, IN DEFINITIVE PROXY OR INFORMATION STATEMENTS INCORPORATED BY REFERENCE IN PART III OF THIS FORM 10-K OR ANY AMENDMENT TO THIS FORM 10-K. [X] AS OF SEPTEMBER 16, 1999, 63,287,447 SHARES OF COMMON STOCK WERE OUTSTANDING, AND THE AGGREGATE MARKET VALUE OF THE SHARES OF COMMON STOCK HELD BY NON-AFFILIATES WAS APPROXIMATELY $72,156,280. (DETERMINATION OF STOCK OWNERSHIP BY NON-AFFILIATES WAS MADE SOLELY FOR THE PURPOSE OF RESPONDING TO THIS REQUIREMENT AND THE REGISTRANT IS NOT BOUND BY THIS DETERMINATION FOR ANY OTHER PURPOSE.) DOCUMENTS INCORPORATED BY REFERENCE NONE. 2 NOVACARE, INC. AND SUBSIDIARIES FORM 10-K -- FISCAL YEAR ENDED JUNE 30, 1999 CONTENTS AND CROSS REFERENCE SHEET FURNISHED PURSUANT TO GENERAL INSTRUCTION G(4) OF FORM 10-K
FORM 10-K FORM 10-K FORM 10-K PART NO. ITEM NO. DESCRIPTION PAGE NO. - --------- --------- ----------- --------- I 1 Business ........................................................ 3 The Company................................................... 3 Overview................................................. 3 Corporate and Capital Structure Changes..................... 3 Continuing Operations....................................... 10 Outpatient Services........................................... 10 Industry Background........................................ 10 Strategy Statement ........................................ 11 Plan for Growth and Operations............................. 12 Business Profile........................................... 13 Competition................................................ 14 Reimbursement/Government Relations......................... 14 Government Regulation ..................................... 15 Employee Services............................................. 15 Industry Background ....................................... 15 Strategy Statement......................................... 16 Plan for Growth and Operations ............................ 16 Business Profile........................................... 18 Information Technology..................................... 20 Competition................................................ 20 Government Regulation...................................... 20 Insurance..................................................... 22 Employees..................................................... 22 Executive Officers of the Registrant ......................... 23 2 Properties....................................................... 23 3 Legal Proceedings................................................ 23 4 Submission of Matters to a Vote of Security Holders.............. 23 II 5 Market for Registrant's Common Equity and Related Stockholder Matters....................................................... 24 6 Selected Financial Data.......................................... 25 7 Management's Discussion and Analysis of Financial Condition and Results of Operations .................................... 26 7a Quantitative and Qualitative Disclosures About Market Risk....... 36 8 Financial Statements and Supplementary Data...................... 37 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure ..................................... 60 III 10 Directors and Executive Officers of the Registrant .............. 61 11 Executive Compensation........................................... 63 12 Security Ownership of Certain Beneficial Owners and Management.................................................... 67 13 Certain Relationships and Related Transactions................... 68 IV 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K.. 69 Signatures...................................................................................... 70
3 PART I ITEM 1. BUSINESS THE COMPANY OVERVIEW NovaCare, Inc. ("NovaCare" or the "Company") was formed in 1985 and is a national leader in physical rehabilitation services and employee services. Physical rehabilitation services are the processes that restore individuals disabled by trauma, injury or disease to their optimal level of functionality and self-sufficiency. Across the health care spectrum, more than 80% of individuals receiving physical rehabilitation services return to the community in productive endeavors or to active retirement. Historically, NovaCare's physical rehabilitation services have been provided in two industry segments: (i) outpatient services -- providing outpatient physical therapy and occupational health rehabilitation services ("PROH") and orthotic and prosthetic services ("O&P") through a national network of patient care centers, and (ii) long-term care services -- providing rehabilitation therapy and health care consulting services on a contract basis to health care institutions, primarily long-term care facilities. As described under "Corporate and Capital Structure Changes" below, the Company sold its long-term care services business on June 1, 1999 and its O&P business on July 1, 1999. The Company's employee services consist of comprehensive, fully integrated outsourcing solutions to human resource needs, including payroll management, workers' compensation risk management, benefits administration, unemployment management and human resource management and consulting services generally provided to small- and medium-sized businesses through its 67% owned subsidiary, NovaCare Employee Services, Inc. ("NCES"). The Company believes it offers better solutions at the best value by providing a convenient integrated complement of services. The Company creates relationships with both its clients and worksite employees by contractually assuming certain administrative, regulatory and financial employer responsibilities with respect to worksite employees in a "co-employment" relationship. CORPORATE AND CAPITAL STRUCTURE CHANGES Long-Term Care Services--Regulatory Changes Reimbursement for long-term care services provided by the Company was primarily through the Medicare program. Medicare is a federally funded health program that provides health insurance coverage for certain disabled persons and persons age 65 or older. Prior to April 10, 1998, Medicare reimbursed long-term care facilities, primarily skilled nursing facilities, for contract therapy services on a cost basis. The fee paid to contract therapy service providers, such as NovaCare, was a reimbursable cost for the long-term care facility. Reimbursement levels were determined based on a reasonable-cost standard. Contract occupational therapy and speech-language pathology services were evaluated based upon the reasonableness of costs incurred by the provider under a "prudent buyer" standard. Specific guidelines existed for evaluating the reasonable cost of physical therapy. The specific guideline system for physical therapy was called "salary equivalency," a method used to determine the prudent hourly cost for physical therapy services in long-term care facilities. Effective April 10, 1998, the Health Care Financing Administration ("HCFA"), the Federal agency responsible for the rules governing Medicare, implemented salary equivalency reimbursement guidelines for occupational therapy and speech-language pathology services and revised guidelines for physical therapy services. With its enactment in June 1997, the Balanced Budget Act of 1997 (the "BBA") revised the manner in which Medicare reimburses long-term care facilities by entirely eliminating cost-based reimbursement. Commencing on July 1, 1998, Medicare Part A services (in-patient services) became reimbursed under a prospective payment system ("PPS") which includes payment for therapy services in an all-inclusive per diem payment based on the acuity level of the patient's illness. Medicare Part B services (outpatient and all other services not covered by Part A) became covered by a fee schedule with total charges subject to an annual cap effective January 1, 1999. 4 As a consequence of these regulatory changes, net revenues for the Company's long-term care services segment decreased from $176.3 million in the quarter ended March 31, 1998, the last quarter prior to the regulatory changes discussed above, to $68.6 million in the quarter ended March 31, 1999, a 61% decline. The decrease in net revenues was primarily due to the implementation of the BBA (i) directly through lower reimbursement rates, and (ii) indirectly due to decreased Medicare patient census in facilities served as a result of the uncertainty of long-term care facilities management with respect to the reimbursement economics of Medicare patients under the BBA. NovaCare's long-term care services segment incurred an EBITDA (earnings before interest, taxes, depreciation and amortization) loss (excluding provision for restructure) of $9.6 million for the quarter ended March 31, 1999, compared with positive EBITDA of $36.5 million for the same quarter of the prior year, a $46.1 million decrease (approximately $184 million annualized). In order to mitigate the effect of these trends in the long-term care services segment, effective March 30, 1999, the Company implemented a restructure plan involving a complete exit of selected markets with low customer and therapist concentration. These markets, generally in the western United States, were unprofitable (net revenues less cost of services, or gross profits, resulted in a loss of approximately $0.2 million in March 1999, or approximately $2 million annualized) and considered unlikely to return to a satisfactory level of profitability in the foreseeable future. In its remaining long-term care services markets, the Company continued to implement a revised operating model during the third quarter ended March 31, 1999 and into the fiscal 1999 fourth quarter, however, the EBITDA loss for the segment continued to be significant. Based on further analysis of the business segment's remaining operations, management determined that in order for the segment to become profitable by December 1999, the following business operating model and cost structure changes had to take place: (i) reduce selling, general and administrative expenses by approximately 50%, (ii) increase clinical productivity by approximately 20%, (iii) increase revenue per customer facility by approximately 15%, (iv) increase new contract sales levels, and (v) decrease customer contract cancellations. Such dramatic changes were necessary due to the size of the EBITDA loss ($7.5 million for the quarter ended March 31, 1999, or approximately $30 million annualized). In management's opinion, the operating model and cost structure changes that the Company would need to make to the business were so extensive, that the remaining long-term care services segment business would not likely be profitable in the foreseeable future. The Board of Directors and management considered the relative economics of the only viable alternatives available to the Company, selling or exiting the remaining long-term care services business, culminating with the Company's divestiture of its stock in its long-term care services subsidiary on June 1, 1999 for a nominal amount to Chance Murphy, Inc., a newly formed and independent company. Chance Murphy, Inc. has hired Integrated Health Services, Inc. to manage the business under a long-term management agreement. In making this determination, management estimated the net cash flows of selling or exiting the businesses. In essence, management's analysis indicated that the costs of terminating the Company's contractual obligations to long-term care services customers, employees and vendors, in the complete market exit, would cost the Company approximately $12 million more than the terms of the divestiture transaction. Pursuant to the divestiture, NovaCare has provided a working capital guarantee of $30 million and the purchaser has agreed to pay to NovaCare the amount, if any, of working capital as of June 1, 1999 in excess of $30 million or, as applicable, to transfer to the Company any remaining accounts receivable relating to periods prior to June 1, 1999 once the working capital guarantee has been satisfied. Under the terms of the transaction, the working capital guarantee is expected to be satisfied by no later than October 29, 1999. At June 30, 1999, $28.2 million of the working capital guarantee remained outstanding. As a result of the exit of selected markets and the divestiture, NovaCare's long-term care services segment recognized an after-tax loss of approximately $93.2 and $30.8 million in the third and fourth quarters of fiscal 1999, respectively. Capital Structure--Highly Leveraged Balance Sheet Due to the Company's lower EBITDA, caused by the impact of regulatory changes in the long-term care services segment, the Company's cash flow from operations was too low to satisfy its debt obligations. This situation characterizes a capital structure that is highly leveraged. NovaCare's total debt at March 31, 1999 was $596.0 million, of which $540.7 was due in less than one year. EBITDA (excluding provision for restructure) for the quarter ended March 31, 1999 was a loss of $2.3 million ($7.3 million positive EBITDA without the long-term care services segment). In comparison, (i) at June 30, 1998, prior to the phase-in of the BBA, the Company's total debt was $508.4 million ($32.1 million current portion) and EBITDA for the quarter ended June 30, 1998 was $46.2 million, (ii) at September 30, 1998, total debt was $576.8 million ($35.2 million current portion) and EBITDA for the quarter was $33.6 million, and (iii) at December 31, 1998, total debt was $581.4 million ($30.8 million current portion) and EBITDA for the quarter was $25.8 million, excluding a $17.8 million provision for restructure. 5 This highly leveraged condition led the Board of Directors and management of the Company to undertake a strategic analysis of the Company's alternatives to satisfy the indebtedness. To assist the Board of Directors and management in assessing the Company's capital structure alternatives, the Company engaged Warburg Dillon Read LLC ("WDR") and Wasserstein Perella & Co., Inc. ("WP"). Sale of Orthotics and Prosthetics Business To partially reduce the Company's debt leverage, on July 1, 1999, the Company sold its O&P business to Hanger Orthopedic Group, Inc. ("Hanger") for $445.0 million, including $407.7 million in cash and the assumption of seller notes of $37.3 million. Of the purchase price, $15.0 million has been placed in escrow in conjunction with a $94.0 million working capital guarantee to Hanger by the Company. The final working capital amount is expected to be settled no later than October 29, 1999. The proceeds from the transaction were used to satisfy the entire balance of the Company's revolving credit facility, with approximately $37 million remaining after transaction-related costs. These funds have been temporarily invested to satisfy working capital requirements and future maturities of other debt obligations. Capital Structure Alternatives Subsequent to the sale of the O&P business, NovaCare remained highly leveraged with indebtedness of approximately $221 million primarily consisting of (i) $175 million of convertible subordinated debentures (the "Debentures") maturing on January 15, 2000 and (ii) $42 million comprising principally subordinated seller notes (the "Seller Notes") related to PROH acquisitions and maturing at various dates through 2007. The only remaining asset of the Company which would provide sufficient funds to satisfy the Debentures is the PROH business. The capital structure alternatives considered by the Company were either obtaining medium-term (three- to five-year) financing secured by PROH assets, selling PROH, selling NovaCare or, in the event all else failed, filing for reorganization under the Bankruptcy Code. Obtaining secured financing was rejected, because even if adequate secured financing could be obtained, the Company would be too highly leveraged (debt would be approximately four times EBITDA) for it to realize sustainable business growth. For example, PROH EBITDA for the latest quarter ended June 30, 1999 annualized (multiplied by four) was $38.5 million. Interest costs would be $18.5 million per year at an assumed 12% annual rate (a typical high-yield interest rate for businesses with a risk profile similar to that of PROH) on average debt of $154 million (four times EBITDA). Assuming a 40% effective tax rate (the combined federal and state income tax rate which would be applicable for PROH on a stand-alone basis), income taxes would be $2.9 million. Further assuming that latest quarter annualized depreciation of $12.8 million is reinvested in capital expenditures to cover the normal replacement of property and equipment, only $4.3 million ($38.5 million EBITDA less $12.8 million capital expenditures, $18.5 million interest and $2.9 million income taxes) would be available to invest in the working capital and acquisitions to sustain business growth. Presuming that all other alternatives were exhausted and bankruptcy protection would be available, management believes that such an action would be so disruptive to customer and employee relations that realizable stockholder value would be substantially eroded. The Board of Directors and management believe that a sale of PROH (the "PROH Sale"), rather than a sale of NovaCare, will optimize the net proceeds to the Company because (i) the tax loss expected on the PROH Sale (approximately $282 million and $183 million at the low and high ends, respectively, of the range of estimated values of PROH set forth below under "Restructuring Proposal--Liquidation Analysis and Estimates") would fully offset the tax due on the gain from the O&P sale and the sale of NCES (the "NCES Sale" - see "Proposed NCES Sale"), a tax advantage not available to the Company if NovaCare is sold, and (ii) the NovaCare sales price would reflect a risk adjusted discount for the potential and perceived risks to buyers with respect to contingent liabilities associated with the Company's exit from a portion of the long-term care services business and the sales of the remaining long-term care services business and O&P, a risk not borne by a buyer who only buys the PROH business. Assuming the PROH Sale is approved by the stockholders in order to satisfy the Company's debt obligations, the only remaining operating business of the Company would be its 67% owned subsidiary, NCES. The Board of Directors and management of the Company determined that the Company should sell NCES because (i) relatively favorable market conditions exist for the sale of professional employer organizations ("PEOs"), (ii) due to the sale of all the other operating businesses of the Company, NCES would be better served being strategically aligned with a business partner other than NovaCare, and (iii) at a 67% ownership level, the tax structure between the Company and NCES is inefficient, requiring the Company to attain 80% ownership or greater in NCES to avoid double taxation of NCES earnings. Although the double taxation issue has been relevant since NCES's initial public offering, prior to the sale of the other operating businesses of NovaCare, it had been outweighed by the benefits of the strategic alignment between NCES and the Company. With regard to strategic alignment, NovaCare founded NCES to leverage the Company's investments in human resource management, information 6 systems, relationship selling, workers' compensation risk management, outsourcing, and management of a dispersed work force. Access to these capabilities in NovaCare's infrastructure on an incremental cost basis was a key premise behind NovaCare's founding of NCES. With the sale of the Company's other operating businesses and consequently the sale and dismantling of its infrastructure, NCES no longer benefits from its affiliation with the Company. Based on due consideration of these alternatives and to optimize stockholder value, the Board of Directors and management engaged WDR to approach a number of potential strategic and financial buyers for the Company's PROH business and WP to approach a number of potential strategic and financial buyers for the Company's 67% ownership interest in NCES. In a proxy statement mailed to stockholders on August 13, 1999 (the "Proxy Statement"), stockholders were notified of a special meeting of stockholders of NovaCare to be held on September 21, 1999 (the "Special Meeting") to consider and vote upon proposals to approve: (i) the PROH Sale, (ii) the NCES sale and (iii) the adoption of the Plan of Restructuring of the Company (the "Restructuring Proposal"). These proposals, which are described below, were approved by the Board of Directors on August 5, 1999. Proposed PROH Sale The Company has engaged WDR to conduct a competitive bidding process among buyers of the stock of the Company's subsidiaries which comprise PROH. No affiliates of the Company or any officers or directors of the Company may participate in the bidding process. In July 1999, at the direction of the Company, WDR contacted 32 potential acquirers of PROH. Of the parties contacted, certain prospective buyers requested and received a confidential information memorandum. On July 30, 1999, letters were distributed to these potential buyers, and preliminary, non-binding indications of interest were submitted in early August 1999. The Company and WDR evaluated the indications of interest based on, among other factors, the price offered and the ability of potential buyers to consummate a transaction. Based on this evaluation, selected potential buyers are presently involved in performing their due diligence efforts with regard to the PROH business. Final non-binding indications of interest are expected to be submitted in late September. The Company and WDR intend to evaluate any final indications of interest based on, among other factors, the price offered, the ability of potential buyers to consummate a transaction and the material terms of acquisition agreements proposed by potential buyers. The Company currently anticipates that the minimum sale price for PROH will be $200 million, including approximately $43 million of debt assumed and the balance of the purchase price in cash. The proceeds of the sale and available cash will be utilized to satisfy the Company's remaining debt obligations and the costs of liquidating the Company and to pay stockholders as reflected in "Restructuring Proposal--Liquidation Analysis and Estimates" below. In determining the anticipated sale price range for the PROH business, the Board of Directors consulted with management of the Company. In making its determination, the Board of Directors reviewed and analyzed the historical financial results and future prospects of the PROH business, comparable valuations of businesses similar to those of PROH to the extent that comparable information was available from public and private transactions and other relevant and appropriate information. The Board of Directors and management determined that a transaction value (cash paid plus debt assumed) expressed as a multiple of the latest quarter annualized ("LQA") EBITDA results was, among other factors, an appropriate measure of comparability. The Board of Directors believed that LQA EBITDA was an appropriate measure of comparability for a transaction such as the PROH Sale, which involves a non-publicly traded subsidiary, since potential strategic and financial buyers traditionally use LQA EBITDA to determine the ability of an acquisition target to cover the capital costs associated with financing acquisitions. Of the eight publicly disclosed sales transactions involving comparable businesses sold since 1993 (the acquisitions by HealthSouth Corp. of Horizon/CMS Healthcare Corp., Professional Sports Care Management Inc., Advantage Health Corp., Caremark Orthopedic Services Inc., the NovaCare Rehabilitation Hospital Division, ReLife Inc. and the rehabilitation hospitals and outpatient centers of National Medical Enterprises Inc. and the acquisition by NovaCare of RehabClinics, Inc.), the lowest EBITDA multiple of LQA results was 6.3 times. The highest EBITDA multiple of LQA results was 11.7 times, with the average multiple being 9.8 times. At a minimum sales price of $200 million, the PROH transaction value would equate to an LQA EBITDA multiple of 5.2 times. Although this LQA EBITDA multiple is below the lowest LQA EBITDA multiple for the publicly disclosed comparable transactions, the Board of Directors believed it was appropriate to use this multiple as a minimum because the most recent publicly disclosed comparable transaction was approximately two and one-half years old and, given the Company's need to satisfy the Debentures by January 15, 2000, the Board of Directors considered it essential to give management the flexibility to consummate a sale of PROH in a timely manner. In connection with the execution of a definitive purchase agreement with a buyer of the PROH business, the Company will request an opinion from WDR as to the fairness, from a financial point of view, to the Company of the consideration to be received by the Company in the sale of the PROH business. 7 If either the PROH Sale is not approved by the stockholders or the conditions to the PROH Sale are not met, the Board of Directors will explore the alternatives then available for the future of the Company. Such alternatives include (i) to refinance the convertible subordinated debentures through a combination of private equity and/or public or private debt, which management believes would demand a high interest rate due to the Company's highly leveraged position and, moreover, there is no assurance that such financing could be obtained, and (ii) in the event the $200 million sale price condition is not met, seeking to obtain stockholder approval of a sale at a lower price. See "Capital Structure Alternatives" for a discussion of the financing alternative. Proposed NCES Sale The Company engaged WP to conduct a competitive bidding process among potential buyers of the Company's stock interest in NCES. No affiliates of the Company or any officers or directors of the Company participated in the bidding process. WP received final proposals from these potential buyers and evaluated the offers received from potential buyers with respect to, among other factors, price per share offered for the common stock of NCES, the ability of potential buyers to consummate a transaction, and the material terms of acquisition agreements proposed by potential buyers. On September 8, 1999, the Company entered into a definitive agreement, subject to certain conditions, to tender its 64% ownership interest in the outstanding stock of NCES at the price of $2.50 per share, or an aggregate of $48.5 million (the "NCES Sale"). (As of August 20, 1999, the Company's 19,400,000 share ownership interest in NCES's common stock was reduced to 64% from 67% as a result of NCES's issuance of additional shares to third parties in accordance with certain contractual obligations). The agreement was reached in conjunction with a definitive agreement by NCES to sell NCES to an investment group comprising Patricof & Co. Ventures, Fidelity Ventures Limited and AFLAC Incorporated (the "Investors"). Under the terms of the agreement by NCES, a new private company, established by the Investors, will acquire all the stock of NCES at a price of $2.50 per share of common stock. The Investors intend to effect the purchase through a cash tender offer to NCES stockholders, which commenced on September 15, 1999, and a subsequent merger of NCES into a new private company managed by the Investors. The Company's tender offer of its ownership interest in NCES is subject to approval of the Company's stockholders at the Special Meeting and the satisfaction of customary closing conditions. The proceeds of the sale will be utilized to pay stockholders as reflected in "Restructuring Proposal - --Liquidation Analysis and Estimates" below. The NCES tender offer is expected to close during October 1999. In the event that the stockholders of NovaCare vote in favor of the NCES Sale, NovaCare intends to vote all of its shares of NCES in favor of a sale of NCES. As the owner of 64% of the outstanding stock of NCES, NovaCare has the ability to approve such a sale under Delaware law. WP has delivered to the Board of Directors of the Company its written opinion (the "Fairness Opinion"), dated September 8, 1999, with respect to the fairness, from a financial point of view, to NovaCare of the consideration to be received by the Company pursuant to the terms of the definitive agreement for the NCES Sale. In connection with rendering their opinion, WP reviewed the definitive agreement for the NCES Sale, reviewed and analyzed certain publicly available business and financial information relating to NCES for recent years and interim period to date, as well as certain internal financial and operating information, including financial forecasts, analyses and projections prepared by or on behalf of NCES and provided to WP for purposes of their analysis, and met with management of NCES to review and discuss such information and, among other matters, NCES's business, operations, assets, financial condition, and future prospects. WP also reviewed and discussed with NovaCare management its views as to the short-term liquidity needs of and capital resources available to the Company. WP reviewed and considered certain financial and stock market data relating to NCES and compared that data with similar data for certain other companies, the securities of which are publicly traded, that WP believes may be relevant or comparable in certain respects to NCES or one or more of its businesses or assets, and reviewed and considered the financial terms of certain recent acquisitions and business combination transactions in the PEO industry specifically, and in other industries generally, that WP believes to be reasonably comparable to the NCES Sale or otherwise relevant to WP's inquiry. WP also performed such other financial studies, analyses, and investigations and reviewed such other information as considered appropriate for purposes of the Fairness Opinion. In WP's review and analysis and in formulating their Fairness Opinion, WP assumed and relied upon the accuracy and completeness of all of the financial and other information provided to or discussed with WP or publicly available, and WP has not assumed any responsibility for independent verification of any of such information. WP assumed and relied upon the reasonableness and accuracy of the financial projections, forecasts, and analyses provided to WP, and WP assumed that such projections, forecasts and analyses were reasonably prepared in good faith and on bases reflecting the best currently available judgments and estimates of NCES's management. WP also considered and took into account NovaCare management's views as to the short-term liquidity needs of and capital resources available to the Company. WP expressed no opinion with respect to such projections, forecasts, analyses and views or 8 the assumptions upon which they were based. In addition, WP has not reviewed any of the books and records of NCES, or assumed any responsibility for conducting a physical inspection of the properties or facilities of NCES or for making or obtaining an independent valuation or appraisal of the assets or liabilities of NCES and no such independent valuation or appraisal was provided to WP. WP expressed no opinion as to the potential tax consequences of the NCES Sale to NovaCare. WP also has assumed that the transactions described in the definitive agreement will be consummated without waiver or modification of any of the material terms or conditions contained therein by any party thereto. WP's opinion was necessarily based on economic and market conditions and other circumstances as they existed and could be evaluated by WP as of the date of the Fairness Opinion. In the ordinary course of WP's business, they may actively trade the debt and equity securities of NovaCare and NCES for their own account and for the accounts of customers and, accordingly, may at any time hold a long or short position in such securities. WP acted as financial advisor to NovaCare in connection with the NCES Sale and will receive a fee for these services, which is contingent upon the consummation of the NCES Sale. In addition, WP has performed various investment banking services for NovaCare from time to time in the past and has received customary fees for rendering such services and WP expects to continue to provide additional financial advisory services to NovaCare for which WP will receive customary fees. The Fairness Opinion addresses only the fairness from a financial point of view to NovaCare of the consideration to be received by the Company pursuant to the NCES Sale and does not express any views on any other terms of the NCES Sale. Specifically, the Fairness Opinion does not address NCES's or NovaCare's respective underlying business decisions to effect the transactions contemplated by the definitive agreement for the NCES Sale. In the event that the NCES Sale is not approved by the stockholders or the closing conditions are not met, the Board of Directors will explore the alternatives then available to the Company. Such alternatives include (i) negotiate the NCES Sale with another buyer, (ii) distribute the Company's interest in NCES to NovaCare stockholders pro rata as a dividend, and (iii) pay existing indebtedness of the Company with shares of NCES stock (provided such stock is valued at not less than $2.50 per share). Restructuring Proposal The Board of Directors has adopted a Restructuring Proposal, which would include the sale and possible distribution of any remaining assets of the Company after consummation of the PROH Sale and the NCES Sale and adoption of a Plan of Restructuring of the Company (the "Plan"). The Company's interest in PROH and NCES represents substantially all of the assets (other than cash or cash equivalents) of the Company. After the sales of PROH and NCES, the Company will endeavor to sell or convert into cash any remaining assets of the Company. As described below, if the Restructuring Proposal is approved, the Company intends to seek to reinvest the net proceeds to the Company from the PROH Sale and the NCES Sale, after the payment of liabilities, in a new business or businesses. Approval of the Restructuring Proposal does not constitute approval of the reinvestment in any new business or businesses and such reinvestment would be subject to further vote and approval of the stockholders of the Company. If the Company is unable, or chooses not, to reinvest any proceeds in a new business or businesses, the Company will liquidate. Approval of the Restructuring Proposal constitutes approval of such liquidation. Under the terms of the Plan and pursuant to Delaware law, the Board of Directors may amend or abandon the Plan prior to the dissolution of the Company without stockholder approval. Furthermore, under the Plan, NovaCare will not liquidate prior to December 31, 2000 (the "Liquidation Date"), unless the Board of Directors determines to liquidate on an earlier date. The Board of Directors does not currently intend to distribute the proceeds of the sales of PROH and NCES to the Company's stockholders, if at all, until after the Liquidation Date. The uses of the proceeds from the sales of PROH and NCES, if consummated, that may be considered by the Board include the development, acquisition and/or investment in or merger with new or existing businesses, distributions to the Company's stockholders, repurchases of the Company's securities and general business purposes. Such activities could include the acquisition of an entire company or companies, or divisions thereof, either through a merger or a purchase of assets, as well as an investment in the securities of a company or companies or, alternatively, a combination with another business in which the Company would not be the surviving corporation. The Company has not entered into any substantive negotiations concerning such acquisitions or investments. Consummation of any investments or business combinations will be subject to vote and approval by the stockholders. If any investments or business combinations are approved by the stockholders of the Company, the Plan will be terminated. 9 The Restructuring Proposal may eventually result in the complete liquidation of all of the Company's assets. If the Restructuring Proposal is approved, and if, prior to the Liquidation Date, no suitable investment or business combination is identified, the Board of Directors will cause the Company to file a certificate of dissolution with the Secretary of State of the State of Delaware, wind up the Company's affairs, attempt to convert all Company assets into cash or cash equivalents, pay or attempt to adequately provide for the payment of all of the Company's known obligations and liabilities and distribute pro rata in one or more liquidating distributions to or for the benefit of the Company's stockholders, as of the applicable record date(s), all of the Company's assets. If the Company is dissolved, pursuant to Delaware law, the Company will continue to exist for three years (or such longer period of time as the Court of Chancery of the State of Delaware shall direct) for the purpose of prosecuting and defending suits against it or enabling the Company gradually to close its business, to dispose of property, to discharge its liabilities and to distribute the remaining assets to the stockholders of the Company. If assets of the Company remain undistributed to its stockholders by December 31, 2001 (the "Final Distribution Date"), those assets would be transferred to a liquidating trust (the "Liquidating Trust") for the pro rata benefit of the stockholders of the Company of record on the Final Distribution Date. Approval of the Restructuring Proposal will constitute stockholder approval of the Plan and of the possible appointment by the Board of Directors of one or more trustees of the Liquidating Trust (the "Liquidating Trustees") and the execution of a liquidating trust agreement with the Liquidating Trustees on such terms and conditions as the Board of Directors shall determine in its absolute discretion. In addition, approval of the Restructuring Proposal will constitute stockholder approval of any and all sales of assets of the Company approved by the Board of Directors or, if applicable, the Liquidating Trustees. The Restructuring Proposal, including the Plan, was approved by the Board of Directors, subject to stockholder approval, on August 5, 1999. If the stockholders do not approve the Restructuring Proposal, the Company's Board of Directors will explore the alternatives then available for the future of the Company, including (i) presenting a new investment opportunity to stockholders or (ii) liquidating the Company. Liquidation Analysis and Estimates Management has estimated the potential realizable values or range of values for its assets, estimated liabilities, the estimated operating losses prior to the sales of PROH and NCES and the cost of liquidation after the Company sells PROH and NCES, assuming those businesses are sold by September 30, 1999. Based on these estimates, which are detailed in the Proxy Statement, as amended through September 10, 1999, the estimated net proceeds available for distribution per outstanding common share upon liquidation of the Company is between $1.76 and $3.51. In determining the range of estimates, the net proceeds from the sales of businesses were estimated based on completed transactions with regard to long-term care services and O&P and proposed transactions for PROH and NCES as described in"Proposed PROH Sale" and "Proposed NCES Sale", respectively, above. The basis for the minimum or low end of the estimated realizable values from the sale of PROH is discussed in "Proposed PROH Sale". The maximum or high end of the range of realizable values for the sale of PROH was determined on the same basis, but utilizing the higher end of the range of comparable factors (LQA EBITDA). All business dispositions were assumed to be divestitures of the Company's ownership in the stock of those businesses. Therefore, all assets and liabilities of those subsidiaries are realized through the net proceeds from these sales, except for the long-term care services sale, pursuant to which, upon satisfying a $30 million working capital guarantee, any accounts receivable of the subsidiary sold which relate to periods prior to the date of the sale (June 1, 1999) are transferred back to NovaCare. The remaining assets and liabilities reflected in the estimates were those assets and liabilities of NovaCare, the parent company, and were estimated to be fully realizable, net of valuation allowances, as reflected in the Company's balance sheet as of March 31, 1999. The Company's results of operations and cash flows for the quarter ended June 30, 1999 were consistent with the estimates contained in the liquidation analysis and estimates in the Proxy Statement. IN DETERMINING THE ESTIMATED NET PROCEEDS AVAILABLE FOR DISTRIBUTION PER OUTSTANDING COMMON SHARE UPON THE LIQUIDATION OF THE COMPANY OF $1.76 TO $3.51, THE METHODS USED BY THE BOARD OF DIRECTORS AND MANAGEMENT IN ESTIMATING THE VALUES AND VALUE RANGES OF THE COMPANY'S ASSETS WERE INEXACT AND MAY NOT APPROXIMATE VALUES ACTUALLY REALIZED. THE BOARD OF DIRECTORS' ASSESSMENT ASSUMES THAT THE ESTIMATES OF THE COMPANY'S LIABILITIES AND OPERATING COSTS ARE ACCURATE, BUT THOSE ESTIMATES ARE SUBJECT TO NUMEROUS UNCERTAINTIES BEYOND THE COMPANY'S CONTROL AND ALSO DO NOT REFLECT ANY CONTINGENT LIABILITIES THAT MAY MATERIALIZE. FOR ALL THESE REASONS, THERE CAN BE NO ASSURANCE THAT THE ACTUAL NET PROCEEDS DISTRIBUTED TO STOCKHOLDERS IN LIQUIDATION WILL NOT BE SIGNIFICANTLY LESS THAN THE AMOUNT ESTIMATED. MOREOVER, NO ASSURANCE CAN BE GIVEN THAT ANY AMOUNTS TO BE RECEIVED BY 10 THE COMPANY'S STOCKHOLDERS IN LIQUIDATION WILL EQUAL OR EXCEED THE PRICE OR PRICES AT WHICH THE COMMON STOCK HAS RECENTLY TRADED OR MAY TRADE IN THE FUTURE. CONTINUING OPERATIONS As discussed above under "The Company - Corporate and Capital Structure Changes -- Long-Term Care Services Regulatory Changes" and "The Company - Corporate and Capital Structure Changes -- Sale of Orthotics and Prosthetics Business", NovaCare had exited or sold substantially all of its businesses previously included in the long-term care services segment as of June 1, 1999 and on July 1, 1999 sold its O&P business previously included in the outpatient services segment. Therefore, the remainder of "Item 1. Business" describes the Company's PROH business in the outpatient services segment and NCES in the employee services segment. OUTPATIENT SERVICES INDUSTRY BACKGROUND Outpatient Physical Therapy and Rehabilitation Services The outpatient physical rehabilitation industry provides skilled services to individuals to minimize physical and cognitive impairments, maximize functional ability and restore lost functional capacity. Outpatient physical rehabilitation services are rendered primarily in outpatient physical rehabilitation facilities, physical rehabilitation hospitals, acute care hospitals, physician offices, industrial settings, schools and patients' homes. The professionals providing these services include physical and occupational therapists, physiatrists and other qualified physical rehabilitation physicians and nurses, speech-language pathologists, respiratory therapists, athletic trainers, recreational therapists, physical rehabilitation counselors and others. According to industry sources, the outpatient physical rehabilitation services industry is a $10 billion industry with 55% of the services provided through approximately 9,200 free standing clinics. The two largest providers, NovaCare and HealthSouth Corp., have a combined market share of 19.8% based on facilities (6.4% and 13.4%, respectively), and 11.5% based on fiscal 1999 revenues (3.0% and 8.5%, respectively). Other significant competitors consist of hospitals and nursing homes offering physical rehabilitation services and private independent operators (physician and therapist entrepreneurs). Industry experts assert that the outpatient physical rehabilitation industry has been growing at a compound annual growth rate of approximately 5% per year since 1992. This trend is expected to continue for several fundamental reasons: Cost Containment Opportunities. Outpatient physical rehabilitation is recognized to be a cost-effective and high-quality substitute for more expensive settings and has been winning market share from acute care and rehabilitation hospitals. According to a 1995 Health Insurance Corporation of America study, for every $1 spent on physical rehabilitation, approximately $30 in future health care, lost productivity and other costs are saved. Outpatient clinics are able to provide their services at lower costs than hospitals because of their lower overhead. In addition, reimbursement changes have encouraged the rapid discharge of patients from acute care hospitals even though they are in serious need of physical rehabilitation services. In addition, growth of the outpatient sector is expected to benefit from changes to the PPS for rehabilitation hospitals, scheduled for October 2000. Outpatient Medical and Technological Innovation. Each year more than three million people regain all, or substantially all, of their musculoskeletal functionality following near-fatal auto accidents, sports injuries, strokes, heart attacks and other medical occurrences, reflecting advances in medical technology and treatment, including more intensive use of physical rehabilitation. In addition, improving technologies and techniques allow for an increasing number of surgical procedures to be performed outside of hospitals. These patients rely heavily on outpatient physical rehabilitation services for restoring functionality. Graying of America: Aging Population Requiring More Rehabilitation Services. The U.S. Bureau of Census estimates that the fastest growing segment of the nation's population is the 65-and-over group. This age group is expected to grow 18% between 1996 and 2010, and 75% from 2010 to 2030. This group requires more physical rehabilitation services than any other age-group, because the incidence of ailments such as hip fractures, strokes and other musculoskeletal conditions is the greatest within this age-group. Combined with the increasing physical activity and the high quality of life expectations of the elderly and the disabled, the growth in this segment of the population promotes increasing utilization of outpatient physical rehabilitation services. 11 Occupational Health Services The occupational health services industry is estimated to be a $26 billion industry. It comprises $4 billion of primary clinical care services, $4 billion of non-injury services and $18 billion of specialty and hospital care services. Analysts estimate that there are more than 2,000 specialized occupational health centers in the United States with 80.2% privately held, single-center businesses. Approximately 40% of work-related injuries require physical rehabilitation. The medical segment of the industry is growing at approximately 9%. Currently, NovaCare competes in the primary care market and in the approximately $1 billion prevention segment of the non-injury services market. The injury segment includes treatment for work-related injuries, physical and occupational rehabilitation therapy, pre-placement physical examinations and evaluations, diagnostic testing and other employer-requested or government-mandated work-related health care services. Non-injury services include case management, utilization management, bill review and processing, on-site safety training and evaluation and vaccination programs. This industry is highly fragmented. The four largest competitors, including the Company, comprise 19.8% of the industry based on number of facilities. Based on 1999 revenues, they have a combined market share of 12.2% of the $5 billion primary care services and prevention services segment of non-injury services. As a result of ballooning expenditures, controlling workers' compensation costs is a high growth, high profile business. Expenditures under the workers' compensation program in the United States grew from $67 billion in 1991 to $93 billion in 1996, a compound annual growth rate of 7%. By 2000, workers' compensation costs are expected to rise to approximately $120 billion. In recent years, medical costs associated with workers' compensation claims have grown faster than those of general healthcare costs, and the medical expenditures portion as a share of workers' compensation expenditures has increased as well. Occupational health companies that are able to leverage utilization management, case management and cost-effective provider networks to return the injured employee to work quickly and reduce the total cost of return-to-work, including both indemnity and medical costs, are positioned to benefit significantly by substantially reducing the costs to employers of work-related illnesses and injuries. Broader definitions of work-related injuries and illnesses covered by workers' compensation laws, regulatory requirements calling for increased health testing (i.e. substance abuse), the shifting of medical costs from group plans to the workers' compensation system, an aging work force, the merging of traditional workers' compensation insurance with disability insurance and, most importantly, the absence of comprehensive cost containment programs will continue to increase the demand for occupational health services. Demographics and advanced technology also will contribute significantly to the growth of this fragmented and localized industry. Increasingly, as both volume of workers' compensation injuries and the cost per injury increase, the industry will continue to consolidate to accommodate employers' needs to coordinate and lower work-related injury costs. The outpatient physical rehabilitation and occupational health industries have been undergoing a trend of consolidation in recent years. Larger successful companies with access to capital and resources have been driving the consolidation as payers in both industries have demonstrated their desire to work with fewer providers to reduce expenses and control utilization, and care providers have needed to focus on economies of scale to minimize variable costs and spread overhead for increasingly complex and sophisticated information systems in a cost sensitive managed care world. STRATEGY STATEMENT NovaCare's outpatient services strategy is to expand its local market presence and enhance relationships with providers, payers and employers to achieve local market leadership. The strategy is based on management's belief that: - Health care is a local business. Local market growth is dependent upon relationships with physicians, hospitals, post-acute care and managed care delivery systems, employers and payers. - The highest margins in a market generally accrue to the provider with the greatest regional market share and scale. 12 - Outpatient physical therapy and occupational health rehabilitation services will continue to experience steady or growing demand because health care payer cost-containment efforts will continue to drive patients toward the most cost-effective, outcome-oriented health care solution to satisfy patients' needs and customers' requirements. - Purchasers of outpatient physical therapy and occupational health rehabilitation services will continue to emphasize cost-effective, clinically proven outcomes in the selection of rehabilitation providers. - Clinical superiority through technological leadership and demonstrated, measurable outcomes should produce a clear competitive advantage. PLAN FOR GROWTH AND OPERATIONS The Company's outpatient services growth and margin improvement plan has four principal components: (i) achieve the leading position in target markets, (ii) enhance the effectiveness of contract pricing, utilization and payer mix disciplines, (iii) implement proprietary information systems, and (iv) reduce labor costs. Achieve the Leading Position in Target Markets. NovaCare has expanded its extensive network of outpatient services sites in target geographic markets through acquisitions, start-up centers and the development of rehabilitation provider networks. Management believes that the size and density of NovaCare's outpatient services network in many markets positions the Company favorably to affiliate with health care delivery systems and to compete for referrals from managed care organizations, physician groups, hospitals and commercial customers. As a result of the Company's forward target market strategy, NovaCare commands the number one or two market position, based on revenues, in 18 of its 31 target markets, and is one of the top three providers in 24 of these markets. NovaCare intends to build and maintain leading market positions in its 31 target geographic markets by leveraging relationships with leading health care providers and brand recognition in these target markets. The Company's goal is to enhance referral and health care system relationships, increase brand awareness and leverage its clinical resources and infrastructure investments in target markets. Management believes that with its outpatient services network, NovaCare is in a strong position to meet the needs of health care systems in a local or regional market. NovaCare offers the attributes that health care systems partners find attractive: (i) dispersed outpatient services capabilities, and (ii) cost-effective, clinically proven outcomes. NovaCare has built a well-recognized brand which is strongly identified with customer needs. The Company's high quality and cost-effective clinical programs with proven treatment results, easily accessible network of clinics providing timely and attentive care and innovative customer service initiatives cause NovaCare to be recognized in its markets as the leading service provider to physicians, payers, employers and patients alike. Closely measured marketing and service initiatives have solidified NovaCare's market share and brand identity in local markets. NovaCare also enhances its brand and clinical reputation by leveraging relationships with 66 national, professional and collegiate sports teams and athletes. Enhance the Effectiveness of Contract Pricing, Utilization and Payer Mix Disciplines. During the period from fiscal 1997 to 1999, increases in patient visits have more than offset declines in average price per visit. The declines resulted from inadequately controlled fee-for-service and capitated pricing awarded to managed care organizations, insufficient control of service utilization by capitated patients, a reduction in Medicare rates and a reduced concentration of higher-priced workers' compensation business. Management expects to reverse this trend by (i) establishing a highly disciplined, centrally controlled pricing and contract management function; (ii) installing the PRONET system (discussed under "Implement Proprietary Systems" below) to better identify and manage emerging pricing and utilization issues; and (iii) marketing to increase the concentration of relatively more attractive payers, especially workers' compensation and commercial insurance. Implement Proprietary Information Systems. NovaCare's growth is supported by a leading-edge proprietary billing, collections and management reporting system, PRONET, which simplifies, standardizes and tightly controls the billing process from patient registration through collections. Major functions, including contract management, patient registration, scheduling, insurance verification, charge entry, bill production, cash application and collections, are all provided in one integrated system. The unique system provides a substantial foundation for operating efficiency and service differentiation. In addition, NovaCare can offer payers the accuracy and timeliness of electronic data interfaces for billing and documentation. The PRONET system has been 13 implemented in over 40% of the Company's outpatient physical rehabilitation business with full implementation planned to be completed by June 30, 2000. The flexibility of PRONET allows for the integration of additional components necessary for complete automation of the outpatient business process, including clinician credentialing, clinical automation, enterprise scheduling and outcomes reporting. The system is built with scaleable technology to allow for volume growth and currently supports 12,000 payer plans. PRONET is also a critical management tool, providing daily clinic-by-clinic data on key operating variables. A state-of-the-art system, STIX, with similar business functionality as PRONET, supports the occupational health business. It enhances NovaCare's relationship with employers and manages the injury care and return-to-work process, as well as reimbursement for injury and non-injury services. Reduce Labor Costs. Clinical and technological improvements and innovation, an improved operating and staffing model and deflation in clinical compensation due to an over supply of clinical staff as a result of the Medicare changes for rehabilitation reimbursement in long-term care facilities and hospitals, are expected to lower the cost of service delivery. BUSINESS PROFILE For the fiscal years ended June 30, 1999 and 1998, outpatient service represented 42% and 52%, respectively, of the Company's net revenues. On July 1, 1999, the Company sold its O&P business as discussed under "The Company - Corporate and Capital Structure Changes." Management believes that NovaCare is the second largest provider of freestanding outpatient physical therapy and rehabilitation services and the fourth largest provider of occupational health services in the United States based on revenues. The Company's national network of 623 clinics comprises stand-alone clinics, hospital-based clinics and employer on-site clinics in 33 states. NovaCare augments its "owned" clinic network with a physical rehabilitation provider network of 755 affiliated clinics in 15 states. Through its owned settings, approximately 2,600 physical and occupational clinical staff develop and deliver individual treatment plans and utilize a sports medicine approach to rehabilitate patients and manage recovery from orthopedic surgery, injuries and disease-related conditions. Outpatient physical therapy and rehabilitation services include: (i) general physical rehabilitation, which is designed to return injured and post-operative patients to their optimal functional capacity, (ii) sports medicine, which is designed to minimize the "downtime" of injured sports participants and safely return them to sports activities, (iii) enhanced performance training, which is designed to improve the muscular and cardiovascular performance of both professional caliber athletes and "weekend warriors", as well as the "senior citizen" population, (iv) industrial rehabilitation, which is designed to reduce work-related injuries and rehabilitate and strengthen injured patients to allow a rapid, safe and productive return to normal job activities, and (v) hospital-based services, which involve providing inpatient and outpatient rehabilitation services on a contract basis to acute care hospitals. Patients are generally referred by physicians (most commonly orthopedists, physiatrists, primary care physicians, internists and neurologists), managed care insurers, workers' compensation insurers, case managers and risk managers of industrial companies. Patients generally receive referrals or prescriptions to receive either a set regimen of treatment or a specific number of therapy sessions lasting various time periods. In a number of states, patients can obtain outpatient therapy services by "direct access," without a physician's referral. The occupational health services business provides medical treatment for work-related injuries and illnesses and a range of health related non-injury services to employers. Practitioners of medical care consist of specialized occupational health physicians, physical therapists, physiatrists and other health care professionals. Medical care for work-related injuries is provided in specialized occupational health clinics. The non-injury services sector includes employment-related physical examinations, drug and alcohol testing, functional capacity testing and other related programs designed to meet specific employer needs. Non-injury health care services also consist of case and utilization management, and prevention programs related to managing an employer's workers' compensation program. The most common work-related injuries are soft tissue injuries, lacerations, moderate trauma injuries to the spine or extremities and exposure to hazardous materials. Work-related injuries are costly to treat and require attention by providers and case managers that have expertise in the field. Work-related injuries cost 1.7 times more to treat than comparable non-work injuries. As a result of higher medical costs, related indemnity benefits and legal and administrative expenses, the cost of on-the-job injuries is extremely high. 14 Customers for occupational health services include workers' compensation insurance companies, commercial and government self-insured employers that operate through third-party administrators and employees covered by various insurance programs. The occupational health services market is highly fragmented and many providers of occupational health care, such as hospital emergency departments and general practitioners, are not specialized in occupational health care. The Company believes that, due to increasing business and regulatory complexity, capital requirements and the development of health care systems in local and regional markets, an increasing number of physicians specializing in occupational health services are seeking to affiliate with larger health care service organizations. NovaCare is one of the four largest occupational health services providers managing work injury rehabilitation and prevention programs for employers through on-site programs and outpatient care through the Company's 35 freestanding occupational health centers and its 588 outpatient rehabilitation clinics. NovaCare performs work-site analyses to assess workplace risk, provides work-site safety programs and helps employers comply with work-related state and federal requirements. COMPETITION The health care industry in general, and rehabilitation in particular, is highly competitive and subject to continual changes in methods of service delivery and provider selection. Rehabilitation is largely a local market business and competition varies considerably among markets. NovaCare competes primarily in the 31 target geographic markets where its outpatient services patient care centers are located. The primary competitive factors in such local markets are: (i) breadth of the providers' patient referral network, (ii) inclusion in payer provider panels, (iii) skilled clinical personnel, and (iv) information systems which can track contracts and patient services to ensure maximum reimbursement. The Company believes that its national and local sponsorship and support of organizations for injured and disabled individuals and affiliations with professional sports teams enhance NovaCare's visibility, brand recognition and competitive position. NovaCare has relationships with 66 national, professional and collegiate sports teams and athletes. The Company competes in local markets with other national, regional and local outpatient rehabilitation service providers, as well as hospital-based outpatient clinics and physician-directed therapy practices. Some of these competitors may have greater patient referral, personnel and geographic resources in certain local markets. In the occupational health services industry, the market is highly fragmented and competitive. The largest competitor in the industry has less than 8% market share. Competitors include other occupational health services companies, independent physicians, hospitals, insurance companies, HMO's, managed care providers and networks of primary care physician specialists. The ability to compete successfully is dependent upon: (i) returning employees to work quickly at the highest rate of functionality and the lowest cost for the care provided, (ii) expertise in treating work-related injuries, (iii) relationships with employers, employees and workers' compensation payer sources, and (iv) information systems to case manage each worker back to their job most appropriately. REIMBURSEMENT/GOVERNMENT RELATIONS The principal sources of reimbursement for outpatient services are workers' compensation insurance, managed care plans, commercial insurance, self-insured employers, Medicare and individual patients on a self-pay basis. Workers' Compensation. Workers' compensation is a state mandated, comprehensive insurance program that requires employers to fund medical expenses, lost wages and other costs resulting from work-related injuries and illnesses. (See "Government Regulation" in the "Employee Services" section below.) Workers' compensation represented approximately 31% of fiscal 1999 PROH net revenues. Managed Care. NovaCare receives revenues under managed care plans either on a discounted fee-for-service basis or, in a growing number of cases, on the basis of capitated fees per covered member per month. Managed care plans represented approximately 25% of fiscal 1999 PROH net revenues. Commercial Insurance. Traditional indemnity insurance plans constituted 17% of fiscal 1999 PROH net revenues. 15 Medicare. NovaCare receives reimbursement by Medicare for outpatient and occupational health care services primarily through NovaCare's certified rehabilitation agencies. See "Government Regulation," discussed later. Medicare insurance programs represented approximately 7% of net revenues for PROH in fiscal 1999. Other. Self-insured employers, individual patients on a self-pay basis and other payer sources represented approximately 20% of fiscal 1999 PROH net revenues. GOVERNMENT REGULATION The health care industry, including outpatient services, is subject to extensive Federal, state and local regulation. Various layers of regulation affect NovaCare's business by requiring licensure or certification of its employees and facilities and controlling reimbursement for services provided. Government and other third-party payers' health care policies and programs have been subject to changes in payment amounts and methodologies for a number of years. NovaCare operates certified rehabilitation agencies to facilitate billing for a portion of its outpatient services. In order to receive Medicare reimbursement directly, outpatient centers must be certified by Medicare as rehabilitation agencies or comprehensive outpatient rehabilitation facilities. The certification criteria relate to the type of facility and its equipment, record keeping, staffing, and service, as well as compliance with all state and local laws. In addition, certain states require facilities to obtain state licensure as a health facility as a requirement for reimbursement. As of June 30, 1999, NovaCare operated 117 certified rehabilitation agencies for outpatient services. Management believes its operations are structured to comply with all applicable rules and regulations. In most states, the employment of therapists by business corporations is a permissible practice. However, several states, including states in which NovaCare operates, have enacted legislation or regulations or have interpreted existing licensing laws to restrict business corporations, such as NovaCare, from practicing therapy through the direct employment of therapists. Management believes its operations are structured to comply with applicable laws and regulations. Various state and Federal laws and regulations govern the relationships between providers of health care services and physicians, including employment or service contracts and investment relationships. These laws and regulations include the fraud and abuse provisions of the Medicare and Medicaid statutes, which prohibit the payment, receipt or offering of any direct or indirect remuneration for the referral of or to induce a referral of Medicare or Medicaid patients or for the ordering or providing of Medicare or Medicaid covered services, items or equipment and the self-referral provisions of Federal and state law which generally prohibit referrals by a physician to persons with whom the physician has certain types of financial relationships. Violations of these provisions may result in civil or criminal penalties for individuals or entities and/or exclusion from participation in the Medicare and Medicaid programs. Management believes it is in compliance with these laws and regulations and has established a compliance program to ensure conformance with these rules as well as other laws and regulations. EMPLOYEE SERVICES INDUSTRY BACKGROUND According to industry analysts, the PEO industry had approximately $22 billion in annual revenues during 1997 with a historical growth rate over the last five years of approximately 28% per year. According to the U.S. Small Business Administration, there are nearly six million businesses in the United States with fewer than 500 employees, employing more than 52 million persons and with $1.2 trillion in aggregate annual payroll. The National Association of Professional Employer Organizations ("NAPEO") estimates that the PEO industry employs fewer than three million worksite employees. The Company believes, therefore, that approximately 49 million of these employees are currently unserved by the PEO industry. The PEO industry is highly fragmented. NAPEO data suggest that there are approximately 2,000 PEOs currently in operation. According to industry analysts, the ten largest PEOs account for approximately 39% of existing revenues in the industry. The Company believes that significant consolidation opportunities exist within the PEO industry due to increasing industry regulatory complexity and capital requirements associated with developing larger service delivery infrastructures, more diversified services and more sophisticated management information systems. 16 Demand for Services. The PEO industry evolved in the early 1980's in response to increasing employment and benefit costs, and the complexities of the legal and regulatory environment for the rapidly expanding small- to medium-sized business sector. The Company believes demand for PEO services will continue to increase as: (i) employment-related governmental regulation grows more complex, (ii) growth continues within the small- to medium-sized business community, (iii) the need to provide health and retirement benefits in a cost-effective convenient manner increases, and (iv) the business and regulatory communities accept and recognize the PEO industry. While various service providers, such as payroll processing firms, benefits and safety consultants and temporary services firms, are available to assist these businesses with specific tasks, such organizations do not typically provide the more comprehensive range of services generally offered by PEOs. PEOs enter into agreements with numerous small- to medium-sized employers, and can, therefore, achieve economies of scale as professional employers and offer benefits packages and human resource services at a level typically available only to larger companies which have greater resources to devote to human resources management. The Company believes PEO services will continue to experience growing demand because of the growing trend among small- to medium-sized employers to: (i) outsource non-core competencies, (ii) seek to reduce employee benefit costs, (iii) avoid employee-related risks and regulatory complexities, and (iv) attract better employees and retain them through improved benefit plans. Effectiveness of Services. According to estimates by the U.S. Small Business Administration, the management of a typical small- to medium-sized business devotes from 7% to 25% of its time to employee-related matters, leaving management with less time to focus on core competencies. Work-related injuries cost employers over $53 billion in medical expenses and lost employee productivity each year, according to industry estimates. Employees are typically attracted to small and medium-sized businesses that provide them with an array of human resources benefits and services typically characteristic of large employers. An industry analyst's study indicated that 40% of the companies that outsourced services to a PEO upgraded their employee benefits offerings and one-fourth of those clients offered health care and other benefits for the first time. STRATEGY STATEMENT The Company's strategy is to be the preferred human resources partner by leveraging operational excellence, technology and strategic alliances to achieve market leadership. The strategy is based on management's belief that: - PEO services will continue to experience growing demand because of the trend among small- to medium-sized employers to: (i) outsource non-core competencies, (ii) reduce employee benefit costs, (iii) avoid employee-related risks and regulatory complexities, and (iv) attract better employees and retain them through improved benefit plans. - The market for PEO services, based on analyst reports, is more than 95% unserved and is expected to grow at the rate of 28% per year for the next five years. - The PEO industry is highly fragmented with significant consolidation opportunities for companies with access to capital, larger service delivery infrastructures, and well developed and sophisticated management information systems. - PEOs typically take a transaction processing approach to their services and do not emphasize the improved workforce performance characteristic of satisfied employees. - In selecting PEO providers, small- to medium-sized businesses will increase their emphasis on cost-effectiveness, service excellence and the breadth of services provided. - Employees are attracted to small- and medium-sized businesses that provide employees with human resource services characteristic of large employers. - Strategic alliances will enable PEOs to enhance endorsement opportunities, widen the network distribution channel and broaden the service/product offering. PLAN FOR GROWTH AND OPERATIONS NovaCare's subsidiary, NCES, is one of the largest (measured by number of worksite employees) PEOs in the United States. NCES commenced operations in October 1996, concurrent with the acquisition of one PEO business. In February 1997, NCES acquired three additional PEOs. NCES completed its initial public offering in November 1997 with an offering of 5,750,000 shares of 17 common stock. In fiscal 1998, NCES acquired PEOs in Arizona and Maryland and in fiscal 1999 acquired PEOs in Utah and New Mexico. As of June 30, 1999, NCES served approximately 4,100 client organizations with approximately 54,300 employees at more than 5,000 worksites primarily in ten industries and 46 states, including approximately 8,700 employees employed by the Company, principally in its outpatient services business. NCES intends to grow through: (i) increasing investment in marketing and sales, (ii) focusing on geographic expansion, (iii) targeting high potential industries and services, (iv) acquiring PEOs and other employee service providers, and (v) entering into strategic alliances. Increasing Investment in Marketing and Sales. The Company's management is experienced in building businesses utilizing focused marketing strategies and professional sales forces. A significant part of NCES's marketing strategy is the continued development of its brand identity. A recognized brand name is a valuable marketing tool. NCES believes that its marketing efforts will benefit from its brand strategy. NCES's brand promise is to provide better human resources solutions at the best value. NCES seeks to create a more satisfying and more productive relationship between its worksite employees and clients by "caring for and about people." By effectively and consistently delivering against this service commitment, NCES believes it will attain a brand name reputation for operational excellence among existing and potential clients. Focusing on Geographic Expansion. NCES has identified key attractive geographic target markets and has established a plan for entering those markets in a disciplined manner. NCES believes that its market development model will enable it to penetrate new markets quickly. This market development model consists of a highly structured sales management control system and efficient selling process. The model includes market research to identify potential client businesses and a direct mail and telemarketing campaign to reach those businesses. In certain cases, NCES may rely on platform acquisitions to achieve scale in a market. Entry priority for specific markets is determined by the number and growth of small- to medium-sized businesses, the state regulatory environment and access to infrastructure to support operations. Once a market is selected, NCES executes an entry plan which includes defining benefit plans and service offerings, recruiting a management sales team, site selection, training and orientation, and launching a specific marketing plan to begin the selling process. Targeting High Potential Industries and Services. Targeted industries will vary from market to market depending on economic characteristics and business demographics of each geographic location. NCES intends to focus on industries with high gross profit per worksite employee and significant workers' compensation profit opportunities. High potential industries are those, such as health care and construction, that NCES believes could benefit most from its risk management expertise (e.g., traditional high workers' compensation classifications) and its offering of an extensive benefits package (e.g., industries facing a shortage of workers). Other high potential industries would include those characterized by rapid growth or change. The sales force is expected to utilize the key industry strategy and become expert in one or more select industries in the markets in which they operate. NCES plans to target larger accounts where it can leverage its unique capabilities and expertise gained from servicing the Company. Acquiring PEOs and Other Employee Service Providers. The Company believes that the opportunities for PEO consolidation are substantial with approximately 2,000 PEOs (according to an estimate by NAPEO) operating in a highly fragmented industry. The Company believes that industry consolidation will be driven by increasing industry and regulatory complexity, increasing capital requirements and the significant economies of scale available to PEOs with a concentration of clients and employees in target markets. NCES intends to make opportunistic acquisitions where appropriate to achieve greater density in targeted geographic markets or expand its service offering. Entering into Strategic Alliances. NCES is creating strategic alliances with service providers to small- and medium-sized businesses. For example, in March 1999, NCES entered into a strategic alliance with AFLAC, Incorporated, the nation's largest provider of supplemental insurance products with approximately 130,000 clients, whereby products and services are cross-sold among each firm's existing and targeted client base. The Florida Home Builders Association, an organization that has approximately 17,000 members with 450,000 worksite employees, has endorsed the Company as the PEO of choice for its members. In addition, the Greater Philadelphia Chamber of Commerce has endorsed NCES as the exclusive PEO of choice for its approximately 6,000 small business client members, under a three-year arrangement. With the trend toward outsourcing non-core competencies, small- and medium-sized businesses typically have service relationships with accountants, attorneys, banks, trade associations and other business advisors. Alliances with these service providers 18 offer a cross-selling opportunity for NCES's services. Other potential alliances being pursued include additional product or service offerings, as well as creating additional sales distribution channels. NCES intends to develop such alliance opportunities as an extension of its marketing and sales capability. BUSINESS PROFILE For the fiscal years ended June 30, 1999 and 1998, employee services represented 58% and 48%, respectively, of the Company's net revenues. As co-employer of worksite employees, NCES assumes responsibility for and manages the risks associated with: (i) worksite employee payroll, (ii) employee-related benefits, such as workers' compensation and health care insurance coverage, and (iii) compliance with certain employment-related governmental regulations that can be effectively managed away from the client's business. The client retains responsibility for supervision and direction of the worksite employees' services in its business and generally remains responsible for compliance with other employment-related governmental regulations that are more closely related to worksite employee supervision. The service fee charged by NCES to its clients covers the cost of certain employment-related taxes, workers' compensation insurance coverage and risk management services, administrative and field services, wages of worksite employees and the client's portion of health and retirement benefit plan costs. NCES also provides other value-added services such as temporary staffing, recruiting, training and human resource consulting. NCES believes its services enable small- and medium-sized businesses to cost-effectively manage and enhance the employment relationship by: (i) controlling the risks and costs associated with workers' compensation, workplace safety and employee-related litigation, (ii) providing employees with high quality health care coverage and related benefits, (iii) managing the increasingly complex legal and regulatory environment affecting employment, (iv) providing payroll and human resource administrative services that are reliable, accurate and delivered in a friendly and caring way, and (v) achieving scale advantages typically available to larger organizations. NCES contractually assumes certain administrative, regulatory and financial employer responsibilities with respect to worksite employees in a "co-employment" relationship. NCES believes its clients benefit from its services by: (i) improving profitability through lowering or controlling costs associated with workers' compensation, health insurance, other benefit coverage and regulatory compliance, (ii) improving productivity through reducing the time and effort expended by business owners and executives to deal with the complexities of employment management, enabling them to focus on their business core competencies and growth, and (iii) improving employee satisfaction and performance. NCES helps its worksite employers improve job satisfaction and performance of the worksite employees by providing improved health care and related benefits, delivering training programs, and delivering dependable payroll and benefits administration. In order to implement its strategy to provide better solutions at the best value, NCES provides six primary categories of employee services: (i) workers' compensation and safety management, (ii) unemployment insurance management, (iii) employee benefits procurement and administration, (iv) human resources and compliance management, (v) payroll management, and (vi) other value-added services. By engaging NCES to provide these services, clients can focus on their core competencies. These services are provided under NCES's PEO client service agreement, which typically has an initial one-year term; thereafter, the agreement is renewed periodically. The agreement is subject to termination by NCES or the client upon 30 days prior written notice. Service revenues, billed to clients along with each periodic payroll, are based on a pricing model that takes into account the gross pay of each employee and a mark-up that includes the estimated costs of employment-related taxes, providing insurance coverage and benefit plans, performing human resource administration, payroll, benefits and compliance management and other services and an administration fee. The specific mark-up varies by client based principally on the workers' compensation classification of the worksite employees, their human resource needs and the size of the client. Accordingly, NCES's average mark-up percentage will fluctuate based on client mix. Clients are required to pay NCES its total fee concurrent with the applicable payroll date. Although NCES is ultimately liable as the employer to pay employees for work previously performed, it retains the right to terminate the PEO client service agreement as well as the worksite employees upon non-payment by a client, which limits any future liability. This right and the periodic nature of payroll, combined with client credit verifications and NCES's client selection process, are used to control this exposure. 19 Workers' Compensation and Safety Management. Workers' compensation is a state-mandated, comprehensive insurance program that requires employers to fund medical expenses, lost wages and other costs that result from work-related injuries and illnesses, regardless of fault and without any co-payment by employees. See "Government Regulation" below for a discussion of workers' compensation. Pursuant to NCES's PEO client service agreement, NCES assumes the obligations of its clients to pay workers' compensation claims. NCES seeks to control its workers' compensation costs through comprehensive risk evaluation of prospective clients, the prevention of workplace injuries, timely intervention with employee injuries, aggressive management of the medical costs related to such injuries and the prompt return of employees to work. NCES seeks to prevent workplace injuries by implementing a wide variety of training and safety programs. NCES's efforts to return employees to work quickly involve both rehabilitation services and the placement of employees in transitional, light-duty positions until they are able to resume their former positions. Unemployment Insurance Management. Pursuant to NCES's PEO client service agreement, NCES also assumes the obligation of its clients to pay unemployment insurance costs. NCES manages its unemployment insurance costs by establishing employee termination procedures, timely responding to unemployment claims, attending unemployment hearings and attempting to reassign employees to other worksites when a reduction in force occurs at any one worksite location. Employee Benefits Procurement and Administration. Pursuant to NCES's PEO client service agreement, NCES is required to provide mandated employee benefits to worksite employees. Additionally, NCES offers worksite employees a voluntary benefits package that includes several health care options, such as point-of-service, preferred provider organizations, health maintenance organizations ("HMOs") and indemnity plans. Supplemental benefit programs offer dental care, prescription drugs, and life and disability insurance options. NCES also offers 401(k) retirement savings, cafeteria style plans to its eligible employees. NCES believes that its ability to provide and administer a wide variety of employee benefits on behalf of its clients tends to mitigate the competitive disadvantage small and medium-sized businesses normally face in the areas of employee benefit cost control and employee recruiting and retention. Human Resources and Compliance Management. Pursuant to NCES's PEO client service agreement, NCES provides comprehensive human resources services to its clients. These services reduce the employment-related administrative burdens faced by its clients, and provide worksite employees with a wide array of benefits typically offered by large employers. NCES develops and administers human resources policies and procedures for each of its clients, relating to, among other things, recruiting, retention programs, performance management, discipline and terminations. NCES also provides orientation, training and development, counseling and substance abuse awareness for worksite employees. By contract, NCES generally assumes responsibility for complying with many employment-related regulatory requirements. In addition, NCES assists its clients in understanding and complying with other employment-related requirements for which NCES does not assume responsibility. Laws and regulations applicable to employers include state and Federal tax laws, state workers' compensation laws, state unemployment laws, occupational safety laws, immigration laws, and discrimination, sexual harassment and other civil rights laws. Payroll Management. Pursuant to the PEO client service agreement, NCES is responsible for payroll processing, check preparation, distribution and recordkeeping, payroll tax deposits, payroll tax reporting, employee file maintenance, unemployment claims and monitoring and responding to changing regulatory requirements. NCES indemnifies the client against NCES's failure to comply with regulatory requirements. Payroll reports are prepared for clients for financial and other recordkeeping purposes. Provision of these services by NCES generally reduces the client's employment liabilities and allows clients to focus on their core business. Other Value-Added Services. NCES offers rehabilitation temporary staffing in the healthcare industry. The rehabilitation temporary staffing service currently can draw on a pool of approximately 6,000 rehabilitation clinicians to provide staff to health care providers. This business is supported by technology, which provides detailed recruitment and sales productivity information for management purposes. It also generates billing and utilization reports for clients. NCES also plans to offer additional value-added services to clients and worksite employees. Such services may include employee recognition programs, travel discount arrangements, vision care, credit union membership, smart cards, warehouse club memberships and various financial services. Some of these services may generate fee income or commissions for NCES. 20 INFORMATION TECHNOLOGY NCES's nationwide information systems network connects its local customer service centers, regional processing centers, worksite employees, clients and service providers. These technologies include, but are not limited to, a combined Internet/Intranet access and electronic mail system, client server-based expertise, which provides distributed processing and rapid implementation of business changes and telecopier to data technology (which eliminates the need for manual data entry). The regional processing centers serve as disaster recovery backup sites, having the capability to handle NCES's operations for a short period of time. NCES currently uses commercially available software to manage information related to payroll processing, benefits administration, human resource management and employee enrollment. NCES has also developed the requirements to create a proprietary information management system to handle the expected growth in worksite employees. COMPETITION The PEO industry consists of at least 2,000 companies (according to an estimate by NAPEO), most of which serve a single market or region. NCES believes that it is the third largest PEO (measured by number of worksite employees) in the United States. According to industry analysts, the ten largest PEOs account for 39% of the existing revenues in the industry. NCES considers its primary competition to include: (i) traditional in-house human resources departments; (ii) other PEOs, and (iii) providers of unbundled employment-related services such as payroll processing firms, temporary employment firms, commercial insurance brokers, human resource consultants, workers' compensation insurers, HMOs and other specialty managed care providers. Competition in the highly fragmented PEO industry is generally on a local or regional basis. Management believes that the primary elements of competition are quality of service, choice and quality of benefits, reputation and price. NCES believes that brand recognition, regulatory expertise, financial resources, risk management, information technology capability, strategic alliances and economies of scale can distinguish a large-scale PEO from the rest of the industry. The Company believes that NCES competes favorably in these areas. NCES believes that barriers to entry into the PEO industry are increasing primarily due to the following factors: (i) the complexity of the PEO business and the need for expertise in multiple disciplines; (ii) the three to five years of experience required to establish experience ratings in key cost areas of workers' compensation, health insurance and unemployment; and (iii) the need for sophisticated management information systems to track all aspects of business in a high growth environment. GOVERNMENT REGULATION NCES is subject to local, state and Federal regulations, which include operating, fiscal and licensing requirements. Adding complexity to NCES's regulatory environment are: (i) uncertainties resulting from the non-traditional employment relationships created by PEOs, (ii) variations in state regulatory schemes, and (iii) the ongoing evolution of regulations regarding health care and workers' compensation. Many of the Federal and state laws and regulations relating to tax, benefit and employment matters applicable to employers were enacted prior to the development of non-traditional employment relationships and, accordingly, do not specifically address the obligations and responsibilities of PEOs or the co-employment relationship. Moreover, NCES's PEO services are regulated primarily at the state level. Regulatory requirements regarding NovaCare's business therefore vary from state to state, and as NCES enters new states it will be faced with new regulatory and licensing environments. There can be no assurance that NCES will be able to: (i) satisfy the licensing requirements or other applicable regulations of any particular state, (ii) provide the full range of services currently offered, or (iii) operate profitably within the regulatory environment of any state in which it does not obtain regulatory approval. The absence of required licenses would require NCES to restrict the services it offers. New legislation or new interpretations of current licensing and regulatory requirements could impose operating or licensing requirements on NCES which it may not be able to satisfy or which could have a material adverse effect on NCES's business, financial condition, results of operations and liquidity. Additionally, interpretation of such legislation or regulation by regulatory agencies with broad discretionary powers could require NCES to modify its existing operations materially in order to comply with applicable regulations. 21 The application of many laws to NCES's PEO services will depend on whether NCES is considered an employer under the relevant statutes and regulations. The Internal Revenue Service ("IRS") is currently examining this issue. See "Employee Benefit Plans" below. In addition, from time to time there have been proposals to enact a statutory definition of employer for certain purposes of the Internal Revenue Code of 1986, as amended (the "Code"). PEO Licensing Requirements. A critical aspect of the growth of the PEO industry has been increasing recognition and acceptance of PEOs by state authorities. While many states do not explicitly regulate PEOs, approximately one-third of the states have passed laws that have licensing or registration requirements for PEOs and several additional states are considering such regulation. Such laws vary from state to state but generally provide for monitoring the fiscal responsibility of PEOs. NCES is licensed in 13 states and expects to be licensed in several more over the next twelve months. State regulation assists in screening insufficiently capitalized PEO operations, imposes requirements regarding payment of wages, taxes, benefits and workers' compensation and resolves issues concerning an employee's status for specific purposes under applicable state law. Because existing regulations are relatively new, there is limited interpretive or enforcement guidance available. The development of additional regulations and interpretation of existing regulations can be expected to evolve over time. Federal and State Employment Taxes. NCES assumes the responsibility and liability for the payment of Federal and state employment taxes with respect to wages and salaries paid to its employees, including worksite employees. To date, the IRS has relied extensively on the common law test of employment in determining employer status and the resulting liability for failure to withhold. However, the IRS has formed a Market Segment Study Group for the stated purpose of examining whether PEOs, such as NCES, are the employers of the worksite employees under the Code provisions applicable to Federal employment taxes and, consequently, whether they are exclusively responsible for payment of employment taxes on wages and salaries paid to such employees. Another stated purpose of the Market Segment Study Group is to determine whether owners of client companies can be employees of PEOs under the Federal employment tax laws. The interpretive uncertainties raised by the Market Segment Study Group may affect NCES's ability to report employment taxes on its own account rather than for the accounts of its clients and would increase administrative burdens on NCES's payroll service function. Employee Benefit Plans. NCES offers various employee benefit plans to its worksite employees, including 401(k) plans, cafeteria plans, group health plans, group life insurance plans, group disability insurance plans and employee assistance programs. Generally, employee benefit plans are subject to provisions of both the Code and the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). In order to qualify for favorable tax treatment under the Code, the plan must be established and maintained by an employer for the exclusive benefit of its employees. The Market Segment Study Group established by the IRS is examining whether PEOs, such as NCES, are the employers of worksite employees under Code provisions applicable to employee benefit plans and consequently able to offer to worksite employees benefit plans that qualify for favorable tax treatment. NCES is unable to predict the actual timing or nature of the findings of the Market Segment Study Group or the ultimate outcome of such conclusions or findings. If the IRS study were to conclude that a PEO is not an employer of its worksite employees for plan purposes, worksite employees might not be able to continue to make contributions to NCES's 401(k) plans or cafeteria plans. NCES believes that although unfavorable to NCES, a prospective application by the IRS of an adverse conclusion would not have a material adverse effect on its financial position and results of operations. If such conclusion were applied retroactively, employees' vested account balances would become taxable immediately, NCES would lose its tax deduction to the extent the contributions were not vested, the plans' trusts would become taxable trusts and penalties could be assessed. In such a case, NCES would face the risk of client dissatisfaction as well as potential litigation. A retrospective application by the IRS could have an adverse effect on NCES's business, financial position, and results of operations and liquidity. While NCES believes that a retroactive disqualification is unlikely, there can be no assurance as to the ultimate resolution of these issues. In addition to the employer/employee relationship requirement described above, pension and profit-sharing plans, including NCES's 401(k) plans, must satisfy certain other requirements under the Code. These other requirements are generally designed to prevent discrimination in favor of highly compensated employees to the detriment of non-highly compensated employees with respect to both the availability of, and the benefits, rights and features offered in, qualified employee benefit plans. NCES applies the nondiscrimination requirements of the Code at both a consolidated and client company level to ensure that its 401(k) plans are in compliance with the requirements of the Code. 22 Workers' Compensation. Workers' compensation is a state-mandated, comprehensive insurance program that requires employers to fund or insure medical expenses, lost wages and other costs resulting from work-related injuries and illnesses. In exchange for providing workers' compensation coverage for employees, employers are not subject to litigation by employees for benefits in excess of those provided by the relevant state statute. In most states, the extensive benefits coverage (for both medical costs and lost wages) is provided through the purchase of commercial insurance from private insurance companies, participation in state-run insurance funds or employer self-insurance. Workers' compensation benefits and arrangements vary on a state-by-state basis and are often highly complex. These laws establish the rights of workers to receive benefits and to appeal benefit denials. Workers' compensation laws also regulate the methods and procedures which NCES may employ in its workers' compensation managed care programs. As a creation of state law, workers' compensation is subject to change by each state's legislature and is influenced by the political processes in each state. Several states have mandated that employers receive coverage only from state-operated funds. Other states have adopted legislation requiring that all workers' compensation injuries be treated through a managed care program. While such legislation may increase the market for NCES's workers' compensation managed care services, it may also intensify the competition faced by NCES for such services. In addition, Federal health care reform proposals include a proposal that may require 24-hour health coverage, in which the coverage of traditional employer-sponsored health plans is combined with workers' compensation coverage to provide a single insurance plan for health problems, whether or not related to work. Incorporating workers' compensation coverage into conventional health plans may adversely affect the market for NovaCare's services and may intensify the competition faced by NCES from HMOs and other health care providers. Moreover, because workers' compensation benefits are mandated by law and are subject to extensive regulation, payers and employers do not have the same flexibility to alter benefits as they have with other health benefit programs. Finally, because workers' compensation programs vary from state to state, it is difficult for payers and multi-state employers to adopt uniform policies to administer, manage and control the costs of benefits. Other Employer-Related Requirements. As an employer, NCES is subject to a wide variety of Federal, state and local laws and regulations governing employer-employee relationships, including the Immigration Reform and Control Act, the Americans with Disabilities Act, the Family and Medical Leave Act, the Occupational Safety and Health Act, wage and hour regulations, and comprehensive local, state and Federal civil rights laws and regulations, including those prohibiting discrimination and sexual harassment. The definition of employer may be broadly interpreted under these laws. Responsibility for complying with various state and Federal laws and regulations is allocated by agreement between NCES and its clients, or in some cases is the joint responsibility of both. Because NCES acts as a co-employer with the client company, it is possible that NCES could incur liability for violations of laws even though NCES is not contractually or otherwise responsible for the conduct giving rise to such liability. NCES's PEO client service agreement generally provides that the client will indemnify NCES for liability incurred as a result of an act of negligence of a worksite employee under the direction and control of the client or to the extent the liability is attributable to the client's failure to comply with any law or regulation for which it has specified contractual responsibility. However, there can be no assurance that NCES will be able to enforce such indemnification and NCES may therefore be ultimately responsible for satisfying the liability in question. INSURANCE The Company maintains professional liability insurance in amounts deemed appropriate by management based upon historical claims and the nature and risks of the business. The Company also maintains property and general liability insurance for the customary risks inherent in the operation of business in general. While NovaCare believes its insurance policies to be adequate in amount and coverage for its current operations, there can be no assurance that any future claims will not exceed the limits of those policies or that such insurance will continue to be available. EMPLOYEES At June 30, 1999, the Company had approximately 54,800 employees. Of these, approximately 8,700 were outpatient services personnel and 46,100 were employee services personnel. Of the employee services personnel, approximately 500 were "administrative" employees and 45,600 were worksite employees of client companies. NovaCare's employees are not represented by any labor union and the Company is not aware of any current activity to organize any of its non-worksite employees. Management considers relations between the Company and its employees to be good. For information with respect to the Company's worksite employees, see "Business Profile" in the "Employee Services" section above. 23 EXECUTIVE OFFICERS OF THE REGISTRANT For the executive officers of NovaCare, see "Item 10 - Directors and Executive Officers of the Registrant". ITEM 2. PROPERTIES NovaCare's principal executive offices are located at 1016 West Ninth Avenue, King of Prussia, Pennsylvania 19406 where NovaCare leases approximately 143,000 square feet of office space. The principal lease for this office space expires in June 2005. In connection with the Company's corporate and capital restructure changes (see "Item 1. - Business - The Company - Corporate and Capital Structure Changes"), the Company is presently negotiating to mitigate its lease obligations with respect to approximately 85,000 square feet of space at its principal executive offices. In addition, the Company leases other office space in various cities within the United States for terms which typically are five years or less. See Note 12 of Notes to Consolidated Financial Statements for information concerning the Company's leases for its facilities. The Company does not anticipate that, where applicable to PROH and NCES, it will experience difficulty in renewing such leases upon their expiration or obtaining different space on comparable terms if such leases are not renewed. The Company believes that these facilities are well maintained and are of adequate size for present and foreseeable needs. NovaCare also has sublease agreements for approximately 16,500 square feet of office space, expiring February 2003 with companies of which NovaCare's Chairman of the Board is a director and/or an executive officer. ITEM 3. LEGAL PROCEEDINGS From time to time, NovaCare is party to certain claims, suits and complaints which arise in the ordinary course of business. Currently, there are no such claims, suits or complaints which, in the opinion of management, would have a material adverse effect on the Company's business, financial condition, results of operations and liquidity. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 24 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS NovaCare's common stock is traded on the New York Stock Exchange (NYSE) under the symbol NOV. On September 3, 1999, there were 1,614 holders of record of common stock. The following table sets forth the high and low sales prices per share of common stock as reported on the NYSE Composite Tape for the relevant periods.
COMMON STOCK PRICES ---------------------- HIGH LOW --------- --------- YEAR ENDED JUNE 30, 1999: First Quarter ............ $ 12.63 $ 2.88 Second Quarter ........... 4.31 2.19 Third Quarter ............ 3.06 1.25 Fourth Quarter ........... 2.25 1.19 YEAR ENDED JUNE 30, 1998: First Quarter ............ $ 17.06 $ 12.50 Second Quarter ........... 17.31 11.81 Third Quarter ............ 14.87 11.87 Fourth Quarter ........... 14.81 10.62
With the exception of 2-for-1 stock splits of common stock effected in the form of stock dividends in June 1987 and July 1991, no other dividends have been paid or declared on common stock since NovaCare's initial public offering on November 5, 1986. NovaCare does not expect to declare any cash dividends on common stock in the foreseeable future. 25 ITEM 6. SELECTED FINANCIAL DATA The following selected financial data should be read in conjunction with NovaCare's consolidated financial statements and the accompanying notes presented elsewhere herein.
YEARS ENDED JUNE 30, ------------------------------------------------------------------- 1999 1998 1997 1996 1995(1) ----------- ----------- ----------- ----------- ----------- STATEMENT OF OPERATIONS DATA: Net revenues ................................ $ 1,477,917 $ 1,037,571 $ 516,925 $ 287,823 $392,039 Gross profit ................................ 210,426 180,153 111,569 66,223 111,068 (Loss) income from continuing operations .... (81,836) (3,214) (18,790) (34,133) 34,841 (Loss) income from continuing operations per share: Basic and assuming dilution ............. (1.30) (0.05) (0.31) (0.56) 0.53
AS OF JUNE 30, ------------------------------------------------------------------- 1999 1998 1997 1996 1995 ----------- ----------- ----------- ----------- ----------- BALANCE SHEET DATA: Total assets................................. $ 1,204,865 $ 1,296,705 $ 977,920 $750,134 $803,538 Total indebtedness........................... 605,557 508,382 342,678 192,215 225,015 Shareholders' equity......................... 393,259 580,673 508,006 484,394 487,635
(1) Includes the results of the medical rehabilitation hospital business which was sold in February 1995. 26 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS NOVACARE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW In the fiscal year ended June 30, 1999, the Company's long-term care services segment experienced a significant decline in net revenues and earnings as a consequence of regulatory changes in the Medicare program, the primary source of reimbursement for long-term care services provided by the Company. The Company implemented a restructure plan involving the complete exit of selected markets and the implementation of a revised operating model, however, the operating loss for the segment continued to be significant. Subsequently, management determined that the remaining long-term care services segment would likely not be profitable in the foreseeable future, therefore, on June 1, 1999 the Company sold substantially all of its business previously included in its long-term care services segment. Accordingly, the operations and the loss on the sale of this segment have been classified as discontinued operations in the current fiscal year's financial statements and all prior periods presented have been reclassified to include the operations of this segment as discontinued operations. In the fiscal years ended June 30, 1998 and 1997, the Company experienced significant revenue and earnings expansion resulting from acquisitions and internal growth of its existing businesses. During fiscal 1999, the Company curtailed its acquisition activity because of capital structure constraints. During fiscal 1998, the Company purchased 90 outpatient services businesses, consisting of 48 outpatient physical therapy and occupational health rehabilitation services ("PROH") businesses, 42 orthotic and prosthetic ("O&P") businesses; and two professional employer organization ("PEO") businesses. During fiscal 1997, the Company acquired 55 outpatient services businesses, consisting of 22 PROH businesses and 33 O&P businesses; and four PEO businesses. During fiscal 1998, NovaCare Employee Services, Inc. ("NCES") sold approximately 5.8 million shares to third parties in an initial public offering, receiving net proceeds of $45.7 million. As of June 30, 1999, the Company retained a 67% interest in NCES. Segment Reporting In fiscal 1998, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information", which requires companies to report operating segments based upon the way a company manages its activities. Because of the Company's reporting, organization and management structure, segment information has been presented for the continuing operations of outpatient services and employee services. As discussed above, the Company's long-term care segment has been reclassified to discontinued operations. See Note 16 to the Condensed Consolidated Financial Statements for financial data for each of the Company's operating segments. Management's discussion and analysis focuses on the amounts and captions provided in Note 7 because they are among the most significant factors used by the Company to manage its business and operating segments. Certain data provided, such as gross profit excluding depreciation, (loss) income from operations excluding provision for restructure and earnings before interest, income taxes, depreciation and amortization ("EBITDA") are not intended to replace gross profit, operating income or net income presented in the basic financial statements as measures of profitability. Continuing Operations Outpatient services relate to the provision of PROH and O&P services through a national network of patient care centers. Employee services are comprehensive, fully integrated outsourcing solutions to human resource needs. These services include payroll management, workers' compensation risk management, benefits administration, unemployment management and human resource management and consulting services, and are generally provided to small and medium-sized business. The Company entered this business on October 1, 1996 with the acquisition of its first PEO business. Effective January 25, 1997, employee services were also provided to the outpatient services and long-term care services segments of the Company. On July 1, 1999, the Company sold its O&P business for $445.0 million, including $407.7 million in cash and the assumption of seller notes of $37.3 million. Of the purchase price, the Company has placed $15.0 million in escrow 27 NOVACARE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) in conjunction with a working capital guarantee to the purchaser. The final working capital amount is expected to be settled no later than October 29, 1999. The Company expects to record a gain on the sale in the first quarter of fiscal 2000 of approximately $50-57 million. The proceeds from this sale were used primarily to pay the entire balance of the Company's revolving credit facility. Net revenues, gross profit and income from operations of the O&P business for fiscal 1999 was $278.8 million, $67.5 million and $41.6 million, respectively. See Note 16 of Notes to Consolidated Financial Statements for financial data for each of the Company's continuing operating segments. Discontinued Operations The Company's long-term care services segment provided rehabilitation therapy and health care consulting services on a contract basis to health care institutions, primarily long-term care facilities. As discussed above, as a result of significant regulatory changes in the Medicare reimbursement to long-term care facilities for the Company's therapy services, the Company implemented a restructure plan in the third quarter of fiscal 1999. The restructure plan related to its decision to completely exit certain long-term care services markets, principally in the Western United States, where it was determined that low customer and therapist concentration would preclude a return to profitability. These markets included California, Colorado, Texas and the Northwest. The Company determined that it would be unable to recover its investment in long-lived assets in the long-term care services operating segment and, accordingly, wrote down all of its investment in these assets and recognized the cost, consisting principally of employee severance costs, of exiting the selected markets. The exit plan called for the termination of approximately 1,300 employees, of which 1,200 were direct care providers in the geographic regions exited and the remainder were general and administrative personnel. Subsequent to the restructuring, the Company determined that in spite of the business operating model and cost structure changes, that its remaining long-term care services operations were unlikely to achieve a sufficient level of profitability to justify continuing that segment's operations. Accordingly, the Company sold its remaining long-term care operations as of June 1, 1999 for a nominal amount and provided a working capital guarantee of $30.0 million to the buyer. The working capital guarantee is expected to be settled by October 29, 1999. In connection with this sale, the Company recognized a pretax loss of $36.7 million which included the working capital guarantee and the write down of certain property and equipment and other assets. Results of operations for the long-term care services operating segment consisted of the following:
YEARS ENDED JUNE 30, (IN THOUSANDS) ------------------------------------------ 1999 1998 1997 --------- --------- --------- Net revenues ....................... $ 351,128 $ 634,534 $ 549,526 Gross profit ....................... 61,247 174,506 148,517 (Loss) income before income taxes .. (84,616) 90,027 90,993 Income tax (benefit) provision ..... (7,680) 28,898 33,293 Net (loss) income .................. $ (76,936) $ 61,129 $ 57,700
Gain from Issuance of Subsidiary Stock During fiscal 1999, the Company recorded a gain of $1.5 million related to the issuance of stock by NCES in connection with acquisitions. During fiscal 1998, the Company recorded a gain of $38.8 million related to the sale of stock by NCES to third parties through an initial public offering of its stock, issuance of stock in connection with conversion of its mandatorily redeemable common stock and acquisitions. 28 NOVACARE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Provision for Restructure During fiscal 1999, the Company decided to exit certain non-strategic markets served by its PROH business within its outpatient services segment resulting in a $30.2 million provision for restructure. The markets consisted of 40 clinics. This decision resulted in a write-down of the value of the related assets to estimated net realizable value. The provision for restructure consists principally of the write-down of excess cost of net assets acquired, net ($28.3 million). The clinics to be disposed of had annualized net revenues of approximately $16.6 million and annualized operating profit of approximately $0.2 million. At June 30, 1999, five of the clinics have been sold for proceeds totaling $0.9 million. The net book value of the remaining assets to be sold is approximately $5.0 million. The Company is reevaluating the decision to dispose of these clinics in light of the sale of PROH described under "Liquidity and Capital Resources - Capital Structure Alternatives". As a result of the Company's decision to exit the long-term care services operating segment and sell the O&P business included in its outpatient services segment, the services the Company required of its employee services segment were substantially reduced. The Company's employee services segment recorded a provision for restructure of $0.9 million, consisting principally of employee severance costs for 49 employees working at its corporate headquarters and lease mitigation costs, to reflect the impact of this decision. The Company anticipates annual savings of $2.6 million as a result of these work force reductions. As of June 30, 1999, 32 employees have been terminated related to this charge. Also as a result of the Company's decision to exit the long-term care services operating segment and sell the O&P business, the Company has implemented a program to substantially reduce its unallocated selling, general and administrative costs incurred at its corporate headquarters. This program (with an aggregate provision of $12.3 million) involves the termination of approximately 74 employees ($3.1 million), lease termination costs ($4.8 million) and long-term information services agreement buyouts ($4.4 million). All of these costs are expected to be expended by June 30, 2000. The Company anticipates that this program will result in annual savings of approximately $30 million when completely implemented. YEAR ENDED JUNE 30, 1999 COMPARED WITH THE YEAR ENDED JUNE 30, 1998 Net revenues for the year ended June 30, 1999 were $1.5 billion, an increase of $440.3 million over fiscal 1998. Gross profit for fiscal 1999 was $210.4 million, an increase of $30.3 million over fiscal 1998. These increases resulted principally from acquisitions ($38.5 million increase in gross profit year-over-year) and internal growth ($1.1 increase in gross profit year-over-year), partially offset by increased cost of services ($6.7 million decrease in gross profit year-over-year). Other operating expenses, excluding the $43.4 million restructure charges described above, were $228.1 million, an increase of $47.9 million over fiscal 1998. Other operating expenses include selling, general and administrative expenses, depreciation (other than depreciation included in cost of services) and amortization of excess cost of net assets acquired ("amortization") and provision for uncollectible accounts. The increase in operating expenses resulted principally from an increase in the provision for uncollectible accounts ($24.2 million), the inclusion of the full year effect of acquisitions completed in fiscal 1998 ($16.8 million), and an increase in other costs ($6.9 million). The increase in the provision for uncollectible accounts resulted from a $15.3 million provision related to PROH receivables aged greater than one year which had been recorded during and prior to the conversion to centralized billing systems and subsequently contracted to independent agencies for collection and an increase in the provision resulting from an increase in net revenues. As a percentage of net revenues, other operating expenses decreased to 15.4% in fiscal 1999 compared to 17.4% in fiscal 1998. This decrease resulted principally from an increase in employee services net revenues, where these operating expenses are typically a smaller percentage of net revenues than in outpatient services. 29 NOVACARE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Depreciation expense, including depreciation reported in cost of services and selling, general and administrative expenses, was $22.1 million, an increase of $0.2 million over fiscal 1998. The increase resulted primarily from the effect of acquisitions in fiscal 1998, capital investments, primarily in information systems and outpatient facilities, offset by a decrease in depreciation of assets written-off in restructuring. Amortization was $22.9 million, an increase of $4.9 million over fiscal 1998, which increase resulted principally from the full-year effect of businesses acquired in fiscal year 1998 and acquisitions in fiscal year 1999. Interest expense was $41.6 million, an increase of $13.3 million over fiscal 1998. Interest expense increased primarily as a result of increased borrowings as discussed under "Liquidity and Capital Resources". The Company recorded an income tax benefit in fiscal year 1999 compared to an income tax expense for fiscal year 1998. The net operating loss and loss on the sale of discontinued operations for fiscal 1999 have been carried back to offset prior fiscal years' income. See Note 13 of Notes to Consolidated Financial Statements for a reconciliation of expected tax benefit to actual tax benefit and the amount of deferred tax assets and liabilities and valuation allowances. OPERATING RESULTS BY SEGMENT Outpatient Services Net revenues for the outpatient services segment were $618.8 million in fiscal 1999, an increase of $83.5 million over fiscal 1998. The increase in net revenues was due principally to the full-year effect of businesses acquired in fiscal 1998 ($89.4 million) and same-market growth ($6.2 million), somewhat offset by a decrease in pricing ($13.4 million). Gross profit (excluding depreciation) was $182.8 million, an increase of $19.0 million over fiscal 1998. The increase in gross profit resulted primarily from the full-year effect of businesses acquired in fiscal 1998 ($30.3 million increase in gross profit year-over-year) somewhat offset by the decrease in pricing which was offset by an increase in volume and productivity ($3.4 million decrease in gross profit year-over-year) and by an increase in cost of products in the O&P business ($6.7 decrease in gross profit year-over-year). Gross profit as a percentage of net revenues ("gross profit margin") decreased to 29.5% in fiscal 1999 compared to 30.6% in fiscal 1998 principally as a result of cost increases and price decreases which the Company was not able to offset by volume and productivity increases. Income from operations was $47.1 million, a decrease of $20.9 million compared with fiscal 1998. The decrease was due to the higher gross profit noted above, offset by higher selling, general and administrative expenses, principally an increase in the provision for bad debts ($24.2 million), the inclusion of the full-year effect of acquisitions completed in fiscal 1998 ($11.4 million) and an increase in other costs ($4.3). The increase in the provision for uncollectible accounts resulted from a $15.3 million provision related to PROH receivables aged greater than one year which had been recorded during and prior to the conversion to centralized billing systems and subsequently contracted to independent agencies for collection and an increase in the provision resulting from an increase in net revenues. Employee Services Employee services net revenues were $1.5 billion in fiscal 1999 (before an intercompany elimination of $685.5 million related to services provided to the outpatient services and long-term care services segments), an increase of $272.9 million over fiscal 1998 net revenues of $1.3 billion (before an intercompany elimination of $769.5 million). The increase in net revenues reflects principally an increase of $359.0 million in third party net revenues due to acquisitions ($200.2 million), entry into new markets ($80.2 million) and same market growth ($78.6 million), 30 NOVACARE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) somewhat offset by a decrease in the employee services segment's contract with the outpatient services and long-term care services segments (the "NovaCare Contract") ($86.3 million). Gross profit (excluding depreciation) was $64.0 million, an increase of $22.5 million over fiscal 1998. The gross profit margin was 4% compared to 3% in fiscal 1998. The increase in gross profit and gross profit margin resulted primarily from the increase in net revenues described above and higher margin services under the NovaCare Contract. Income from operations was $18.0 million, an increase of $7.1 million over last year. The increase resulted from the improvement in gross profit noted above, partially offset by additional costs incurred to support same market growth ($10.0 million) and higher selling, general and administrative expenses related to acquisitions ($5.4 million). Income (Loss) from Discontinued Operations Net revenues for long-term care services were $351.1 million in fiscal 1999, a decrease of $283.4 million from fiscal 1998. The decrease in net revenues resulted primarily from lower reimbursement rates and utilization of the Company's services resulting from significant regulatory changes in the Medicare reimbursement of long-term care services. Gross profit (excluding depreciation) was $64.1 million in fiscal 1999, a decline of $113.7 million from fiscal 1998. The gross profit margin was 18.3% in fiscal 1999 compared with 28.0% in fiscal 1998. The decrease in gross profit and gross profit margin resulted primarily from the decrease in net revenues described above without a corresponding reduction in therapist's compensation and benefits and other costs of providing services. Loss before income taxes was $84.6 million in fiscal 1999 compared to income before income taxes of $90.0 million in fiscal 1998. The decrease in income from operations resulted primarily from the decrease in gross profit described above coupled with an increase in selling, general and administrative expenses and a $98.6 million provision for restructure to exit selected long-term care markets and to write-off the Company's investment in long-lived assets that the Company will not be able to recover. Loss on Sale of Discontinued Operations Effective June 1, 1999, the Company sold all of the issued and outstanding stock of its remaining subsidiary of the Company's long-term care services segment for a nominal amount. Pursuant to the sale agreement, the Company guaranteed the purchaser working capital of $30.0 million. The purchaser has agreed to pay the Company the amount, if any, of working capital at June 1, 1999 in excess of $30.0 million or, as applicable, to transfer any remaining accounts receivable relating to periods as of June 1, 1999 once the working capital guarantee has been satisfied. As a result of this transaction the Company has recorded a pretax loss of $36.7 million ($30.8 million after-tax) on the sale of discontinued operations. YEAR ENDED JUNE 30, 1998 COMPARED WITH THE YEAR ENDED JUNE 30, 1997 Net revenues for the year ended June 30, 1998 were $1.0 billion, an increase of $520.6 million over fiscal 1997. Gross profit for fiscal 1998 was $180.2 million, an increase of $68.6 million over fiscal 1997. These increases resulted principally from acquisitions ($45.0 million increase in gross profit year-over-year) and internal growth ($23.6 million increase in gross profit year-over-year). Other operating expenses were $180.2 million, an increase of $58.6 million over fiscal 1997. The increase in operating expenses resulted principally from additional costs incurred in the expansion of the Company's employee services business ($16.1 million), the inclusion of higher expenses resulting from acquisitions completed in 1998 31 NOVACARE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) and 1997 ($16.2 million), additional provision for uncollectible accounts resulting from higher net revenues ($7.9 million) and those costs required to support internal growth ($18.4 million). As a percentage of net revenues, other operating expenses decreased to 17.4% in fiscal 1998 compared to 23.6% in fiscal 1997. This decrease resulted principally from an increase in employee services revenues, where these operating expenses are typically a smaller percentage of net revenues than in outpatient services. Depreciation expense, including depreciation reported in cost of services and selling, general and administrative expenses, was $21.8 million, an increase of $4.8 million over fiscal 1997. The increase resulted primarily from the effect of acquisitions in fiscal 1998 and 1997 and capital investments, primarily in information systems and outpatient facilities. Amortization was $18.0 million, an increase of $6.6 million over fiscal 1997, which increase resulted from acquired businesses. Interest expense was $28.3 million, an increase of $13.1 million over interest expense of $15.2 million in fiscal 1997. Interest expense increased primarily as a result of increased borrowings as discussed under "Liquidity and Capital Resources". In fiscal 1998, the Company recorded income tax expense on income before income taxes, whereas in fiscal 1997 the Company recorded an income tax benefit on loss before income taxes. See Note 13 of Notes to the Consolidated Financial Statements for a reconciliation of expected tax expense (benefit) to actual tax expense (benefit). OPERATING RESULTS BY SEGMENT Outpatient Services Net revenues for the outpatient services segment were $535.3 million in fiscal 1998, an increase of $157.3 million over fiscal 1997. The increase in net revenues was due principally to businesses acquired in fiscal 1998 and the full-year effect of businesses acquired in fiscal 1997 ($150.9 million) along with same-market growth in O&P and occupational health ($6.1 million). Gross profit (excluding depreciation) was $163.8 million, an increase of $52.3 million over fiscal 1997. The increase in gross profit resulted primarily from businesses acquired in fiscal 1998 and the full-year effect of businesses acquired in fiscal 1997 ($41.6 million increase in gross profit year-over-year), same market growth in O&P and occupational health ($4.4 million) and cost reductions in physical rehabilitation ($3.8 million). Gross profit margin increased to 30.6% in fiscal 1998 compared to 29.5% in fiscal 1997 principally as a result of improved productivity. Income from operations was $68.0 million, an increase of $20.4 million compared with fiscal 1997. The increase was due to the higher gross profit noted above, partially offset by an increase in the provision for bad debts ($7.9 million) higher depreciation and amortization expense ($8.0 million), and higher selling, general and administrative expenses ($16.0 million). The increase in those costs was principally a result of expenses associated with or in support of businesses acquired. Employee Services Employee services net revenues were $1.3 billion in fiscal 1998 (before an intercompany elimination of $769.5 million related to services provided to the outpatient services and long-term care services segments), an increase of $877.6 million over fiscal 1997 net revenues of $394.2 million (before an intercompany elimination of $255.3 million). This increase in total net revenues is due to an increase in net revenues of $514.2 million under the NovaCare Contract and an increase of $363.4 million in third party net revenues. Gross profit (excluding 32 NOVACARE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) depreciation) was $41.5 million in fiscal 1998, an increase of $29.3 million over fiscal 1997. Income from operations was $10.9 million, an increase of $8.0 million over fiscal 1997. The increases in net revenues, gross profit and income from operations resulted from: (i) a full year's operation under the NovaCare Contract in fiscal 1998 compared with only five months in fiscal 1997, as well as a 5% increase in the number of worksite employees covered by the NovaCare Contract in fiscal 1998, (ii) a full year of operations in fiscal 1998 compared to only nine months in fiscal 1997 (the employee services segment commenced operations October 1, 1996 with the acquisition of its first PEO business), (iii) the full-year effect of fiscal 1997 acquisitions, (iv) acquisitions completed in fiscal 1998, and (v) same market growth. Income (Loss) from Discontinued Operations Net revenues for long-term care services were $634.5 million in fiscal 1998, an increase of $86.0 million over fiscal 1997. The increase in net revenues resulted primarily from new contract sales and price increases on existing contracts, partially offset by lower reimbursement rates in the fourth quarter of fiscal 1998 caused by the implementation of the salary equivalency reimbursement system for speech and occupational therapies. Gross profit (excluding depreciation) was $177.8 million in fiscal 1998, an increase of $26.0 million over fiscal 1997. The gross profit margin was 28.0% in fiscal 1998 compared with 27.6% in fiscal 1997. The improvement in gross profit and gross profit margin resulted from an increase in new customer contracts coupled with reduced salary and wage costs per employee, due to the conversion of the Company's clinical workforce from fixed salary compensation to variable hourly compensation and improved productivity. Income before income taxes and before a provision for restructure of $23.5 million, was $113.5 million, an increase of $22.5 million over fiscal 1997. The increase resulted from the higher gross profit noted above, partially offset by slightly higher selling, general and administrative costs and higher depreciation and amortization incurred to support business growth. LIQUIDITY AND CAPITAL RESOURCES Cash Flows At June 30, 1999, cash and cash equivalents totaled $23.3 million, a decrease of $9.4 million from June 30, 1998. Cash used in continuing operations was $102.9 million in fiscal year 1999 compared to $0.7 million in fiscal 1998 and to $6.6 million in fiscal 1997. The $102.2 million increase from fiscal 1998 to 1999 resulted from higher earnings, after non-cash charges, of $2.4 million, offset principally by the timing of payments and amounts of accounts payable and accrued expenses and income taxes of $112.0 million. The $5.9 million decrease in cash flows used in continuing operating activities in fiscal 1998 compared to fiscal 1997 resulted from an increase in earnings, after non-cash charges, of $10.1 million coupled with an increase in accounts payable and accrued expenses and income taxes of $28.3 million, offset by an increase in accounts receivable, inventories and other assets of $33.2 million. Cash provided by discontinued operations was relatively constant at $73.3 million in fiscal 1999 and $73.9 million in fiscal 1998 which was up from $53.9 million in fiscal 1997. Although the profitability of the segment was drastically reduced in the second half of fiscal 1999, the Company continued to collect accounts receivable that it had recorded in previous quarters. 33 NOVACARE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Investing activities used $74.3 million of cash in fiscal 1999 compared with $214.0 million and $187.8 million in fiscal 1998 and 1997, respectively. Cash paid for acquisitions decreased to $61.1 million in fiscal 1999 compared with $180.6 million in fiscal 1998, which was an increase from $164.1 million paid in fiscal 1997. During fiscal 1999, the Company curtailed its acquisition activity because of capital structure constraints. Capital expenditures for continuing operations were $22.2 million in fiscal 1999 up from $17.9 million in fiscal 1998 and $14.8 million for fiscal 1997 as the Company continued to invest in internally and externally developed software and equipment needed for technological efficiency in clinical and administrative activities in support of cost reduction initiatives. Capital expenditures for discontinued operations decreased slightly to $10,957 in fiscal 1999 from $13,221 in fiscal 1998 which increased from $7,278 in fiscal 1997 as the Company continued, to the date of sale, to invest in internally and externally developed software needed to support its clinical programs and outcomes. The Company's major financing activities consisted of borrowings, net of repayments, of $92.5 million in fiscal 1999, compared with net borrowings of $97.3 million in fiscal 1998, compared with net borrowings of $87.0 million in 1997. Also, during fiscal 1998 NCES sold approximately 5.8 million shares to third parties in an initial public offering, receiving net proceeds of $45.7 million. The net proceeds of the offering were used principally to pay obligations associated with acquisitions and other debt. As of June 30, 1999, the Company retained a 67% interest in NCES after reductions in its ownership interest for the initial public offering and NCES shares issued in the conversion of its mandatorily redeemable common stock and to sellers of acquired PEO businesses. Credit Agreements The Company has a revolving credit facility with a syndicate of lenders that is collateralized by substantially all of the Company's assets. The maximum amount available at June 30, 1999 was $400.0 million. The terms of the facility were amended during fiscal 1999 to shorten the maturity date from June 30, 2003 to December 31, 1999 and to change the interest rate from the London Interbank Offered Rate ("LIBOR") plus a range of 0.875% to 1.5%, depending on certain financial ratios, to LIBOR plus 3%. The Company is also charged a commitment fee of 0.5% on the average daily available balance. The entire amount of the facility outstanding at June 30, 1999 was repaid on July 1, 1999 from the proceeds of the O&P sale. Subsequent to such repayment, the maximum amount available under the facility was reduced to $35.0 million. Outstanding letters of credit, which were $1.1 million at June 30, 1999, further reduce the amount available under the facility. NCES has a revolving credit facility with a syndicate of lenders that is collateralized by a pledge of (i) NCES's subsidiaries' common stock, (ii) the assets of NCES and its subsidiaries, and (iii) the Company's interest in the common stock of NCES. The facility expires in November 17, 2000 and carries an interest rate, depending on certain financial ratios, equal to (i) LIBOR plus a range of 1.375% to 2.5% or (ii) the lead lending bank's prime rate plus a range of 0.125% to 1.5%. As of June 30, 1999, $23.0 million was available under the facility. Capital Structure Alternatives Due to the Company's lower income from operations and EBITDA, caused primarily by the impact of regulatory changes in the long-term care services segment, the Company's cash flow from operations was too low to satisfy its debt obligations. This situation characterizes a capital structure that is highly leveraged. The Company's total debt at June 30, 1999 was $605.6 million, of which $551.3 million is due in less than one year. EBITDA (excluding the provision for restructure) for the quarter ended March 31, 1999 was a loss of $2.3 million ($7.3 million positive EBITDA without the long-term care services segment). In comparison, (i) at June 30, 1998 the Company's total debt was $508.4 million ($32.1 million current portion) and EBITDA for the quarter ended June 30, 1998 was $46.2 million, (ii) at September 30, 1998, total debt was $576.8 million ($35.2 million current portion) and EBITDA for the quarter was 34 NOVACARE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) $33.6 million, and (iii) at December 31, 1998, total debt was $581.4 million ($30.8 million current portion) and EBITDA for the quarter was $25.8 million, excluding a $17.8 million provision for restructure. This highly leveraged condition led the Board of Directors and management of the Company to undertake a strategic analysis, during the fourth quarter of fiscal 1999, of the Company's alternatives to satisfy the indebtedness. To partially reduce the Company's debt leverage, on July 1, 1999, the Company sold its O&P business to Hanger Orthopedic Group, Inc. ("Hanger") for $445.0 million, including $407.7 million in cash and the assumption of seller notes of $37.3 million. Of the purchase price, the Company has placed $15.0 million in escrow in conjunction with a $94.0 million working capital guarantee to Hanger. The final working capital amount is expected to be settled by no later than October 29, 1999. The proceeds from the transaction were used to satisfy the entire balance of the Company's revolving credit facility, with approximately $37 million remaining after transaction-related costs. These funds have been temporarily invested to satisfy working capital requirements and future maturities of other debt obligations. Subsequent to the sale of the O&P business, NovaCare remained highly leveraged with indebtedness of approximately $221 million consisting primarily of (i) $175 million of convertible subordinated debentures (the "Debentures") maturing on January 15, 2000 and (ii) $42 million comprising principally subordinated seller notes (the "Seller Notes") related to acquisitions and maturing at various dates through 2007. The only remaining asset of the Company which would provide sufficient funds to satisfy the Debentures, is the PROH business. The capital structure alternatives considered by the Company were either obtaining medium-term (three- to five-year) financing secured by PROH assets, selling PROH, selling NovaCare or, in the event all else failed, filing for reorganization under the Bankruptcy Code. Obtaining secured financing was rejected, because even if adequate secured financing could be obtained, the Company would be too highly leveraged (debt would be approximately four times EBITDA) for it to realize sustainable business growth. Therefore, the Board of Directors and management believes that a sale of PROH (the"PROH Sale") is the most attractive alternative to maximize value and has engaged an investment banking firm to solicit offers to purchase PROH. The PROH Sale requires approval by the stockholders of the Company. On September 8, 1999, the Company entered into a definitive agreement, subject to certain conditions, to tender its interest in NCES, 19,400,000 shares, at the price of $2.50 per share (the "NCES Sale"). Under the terms of the agreement the purchaser will acquire all of the outstanding shares of NCES for $2.50 per share through a cash tender offer which commenced on September 15, 1999 and is expected to close during October 1999. The Company's tender offer of its interest in NCES is subject to approval by the Company's stockholders and the satisfaction of customary closing conditions. If either the stockholders do not approve the PROH Sale or the conditions to the PROH Sale are not met, the Board of Directors will explore the alternatives then available for the future of the Company. Such alternatives include (i) refinancing the convertible subordinated debentures through a combination of private equity and/or public or private debt, which management believes would demand a high interest rate due to the Company's highly leveraged position and, moreover, there is no assurance that such financing could be obtained, and (ii) in the event the $200 million sale price condition is not met, seeking to obtain stockholder approval of a sale of PROH at a lower price. In the event that the stockholders do not approve the NCES Sale or the closing conditions are not met, the Board of Directors will explore the alternatives then available to the Company. Such alternatives include (i) negotiate the NCES Sale with another buyer, and (ii) distribute the Company's interest in NCES to NovaCare stockholders pro-rata as a dividend, and (iii) pay existing indebtedness of the Company with shares of NCES's stock (provided such stock is valued at not less than $2.50 per share). If the stockholders do not approve the restructuring proposal, the Company's Board of Directors will explore the alternatives then available for the future of the Company, including (i) presenting a new investment 35 NOVACARE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) opportunity to stockholders or (ii) liquidating the Company. If the $175 million convertible subordinated debentures cannot be paid due to the Company's inability to (i) obtain stockholders approval of the PROH sale, (ii) meet the conditions of a PROH sale, or (iii) secure refinancing in the event PROH is not sold, the alternatives available to the Company will be limited to (i) a sale of the Company, (ii) negotiating alternative debenture payment terms, including conversion to common stock, and (iii) protection under the Bankruptcy Code. The Company is unable to predict the ultimate outcome of the stockholder voting on these matters or the likelihood of successfully concluding any other available alternative. INFLATION A significant portion of the Company's operating expenses have been subject to inflationary increases. Prior to fiscal 1999, therapist salary increases historically have exceeded other medical industry salary rate increases due to the existing supply shortage and the Company had been unable to offset any portion of these inflationary increases through charge increases, but has mitigated somewhat the effect of these salary increases through expanding services and increasing operating efficiencies. Commencing in 1999, however, the Company has begun to see an increase in the availability of therapists, due principally to changes in the regulatory environment affecting the reimbursement of therapy services. The supply of therapists coupled with the Company's migration to an operating model that emphasizes the increased use of well-trained therapy assistants and aides, closely supervised by licensed professionals, is expected to lessen the overall salaries and wages of the Company's clinical staff. However, it is uncertain whether the deflation in clinical staff costs will offset the pricing deflation in health care services. Management believes that the Company can continue to offset most, if not all, of the potential effects of inflation through salary and wage deflation, business expansion and increasing operating efficiencies. YEAR 2000 READINESS Historically, certain computer programs have been written using two digits, rather than four digits, to define the applicable year. This could lead, in many cases, to a computer's recognizing a date using "00" as 1900 rather than the year 2000. This phenomenon could result in major computer system failures or miscalculations, and is generally referred to as the "Year 2000" problem or issue. The Company has assessed its exposure to the Year 2000 problem, and has substantially completed its response to that exposure. Generally, the Company has Year 2000 exposure in three areas: (i) financial and management operating computer systems used to manage the Company's business, (ii) microprocessors and other electronic devices included as components of therapy and other equipment used by the Company ("embedded chips") and (iii) computer systems used by third parties, in particular financial institutions, customers and suppliers of the Company. The Company estimates the remaining cost of this effort to be approximately $1.0 million, including $0.8 million of capital costs for new computers and related equipment. This amount does not include costs for computer software developed in order to provide or improve functionality. As of June 30, 1999, the Company had already spent approximately $3.8 million in this effort. The Company has increased its overall information technology's budget to accommodate Year 2000 issues and has not delayed other projects critical to the Company's business. The Company has substantially completed Year 2000 testing and remediation on its financial and management operating systems. All software programs are Year 2000 compliant. All infrastructure components (hardware, telecommunication devices) are compliant except for a small percentage of noncompliant desktop and laptop computers which are expected to be remediated by October 1999. The Company has completed an inventory and assessment of its exposure to embedded chips in its facilities in the areas of medical, office and physical-plant equipment. A small percentage of items are affected, and remediation of the equipment is expected to be completed by September 30, 1999. 36 NOVACARE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) The Company has received written correspondence from its major vendors and management is satisfied that the Company does not have significant exposure to Year 2000 problems associated with vendors. The Company continues to interview payers to determine their exposure to Year 2000 issues, their anticipated risks and responses to those risks, and expects to be completed with remediation activities, if any by October 1999. The Company has established the majority of its business continuity plan which is expected to be fully executed by October 1999. If the Company is unsuccessful in completing remediation of non-compliant hardware or if customers or vendors, which have indicated Year 2000 readiness, have not or cannot rectify Year 2000 issues, the Company could incur additional costs, which may be substantial, to develop alternative methods of managing its business and replacing non-compliant equipment, and may experience delays in payments by customers or to vendors. CAUTIONARY STATEMENT Except for historical information, matters discussed above including, but not limited to, statements concerning future growth, are forward-looking statements that are based on management's estimates, assumptions and projections. Important factors that could cause results to differ materially from those expected by management include reimbursement system changes, the productivity of clinicians, pricing of payer contracts, management retention and development, management's success in developing and introducing new products and lines of business, the ability of the Company, its customers and suppliers to complete assessment, testing and remediation of Year 2000 issues, the ability of the Company to improve its cash flow from operations, the ability to complete the sale of the physical rehabilitation and occupational health business, adverse Internal Revenue Service rulings with respect to the employer status of employee services businesses and the Company's ability to implement the employee services business model. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company does not engage in trading market risk sensitive instruments and does not purchase as investments, as hedges or for purposes "other than trading" instruments that are likely to expose the Company to market risk, whether it be from interest rate, foreign currency exchange, or commodity price risk. The Company has entered into no forward or futures contracts, purchased no options and entered into no swap arrangements. The Company's primary market risk exposure is that of interest rate risk. A change in the market interest rate would affect the rate at which the Company could borrow funds under its credit facilities. 37 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOVACARE, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE DATA)
AS OF JUNE 30, ------------------------------ 1999 1998 ----------- ----------- ASSETS Current assets: Cash and cash equivalents .................................. $ 23,277 $ 32,760 Accounts receivable, net of allowance in 1999 and 1998 of $38,459 and $35,550, respectively ......................... 193,407 187,906 Income tax receivable ...................................... 23,022 -- Inventories ................................................ 44,651 38,207 Deferred income taxes ...................................... 37,422 4,519 Net assets of discontinued operations ...................... 44,388 -- Other current assets ....................................... 22,323 21,365 ----------- ----------- Total current assets ............................... 388,490 284,757 Property and equipment, net .................................. 59,744 61,443 Excess cost of net assets acquired, net ...................... 729,947 692,283 Net assets of discontinued operations ........................ -- 216,886 Investment in joint ventures ................................. 15,120 14,881 Deferred income taxes ........................................ 1,669 155 Other assets, net ............................................ 9,895 26,300 ----------- ----------- $ 1,204,865 $ 1,296,705 =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current portion of financing arrangements .................. $ 551,320 $ 32,074 Accounts payable and accrued expenses ...................... 131,310 145,584 Income taxes payable ....................................... 2,192 981 ----------- ----------- Total current liabilities .......................... 684,822 178,639 Financing arrangements, net of current portion ............... 54,237 476,308 Deferred income taxes ........................................ 39,091 29,171 Other ........................................................ 5,031 13,608 ----------- ----------- Total liabilities .................................. 783,181 697,726 ----------- ----------- Minority interest in consolidated subsidiaries ............... 28,425 18,306 Commitments and contingencies ................................ -- -- Shareholders' equity: Common stock, $.01 par value; authorized 200,000 shares, issued 68,561 shares in 1999 and 67,935 shares in 1998 .... 686 679 Additional paid-in capital ................................. 274,603 273,157 Retained earnings .......................................... 160,644 350,255 ----------- ----------- 435,933 624,091 Less: Common stock in treasury (at cost), 5,308 shares in 1999 and 5,401 shares in 1998 ............................. (42,674) (43,418) ----------- ----------- Total shareholders' equity ......................... 393,259 580,673 ----------- ----------- $ 1,204,865 $ 1,296,705 =========== ===========
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 38 NOVACARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE YEARS ENDED JUNE 30, ------------------------------------------------ 1999 1998 1997 ----------- ----------- ---------- Net revenues ............................................ $ 1,477,917 $ 1,037,571 $ 516,925 Cost of services ........................................ 1,267,491 857,418 405,356 ----------- ----------- ---------- Gross profit ........................................ 210,426 180,153 111,569 Selling, general and administrative expenses ............ 162,719 144,002 96,897 Provision for uncollectible accounts .................... 42,540 18,287 13,514 Amortization of excess cost of net assets acquired ...... 22,866 17,965 11,244 Provision for restructure ............................... 43,395 -- -- ----------- ----------- ---------- (Loss) from operations .............................. (61,094) (101) (10,086) Gain from issuance of subsidiary stock .................. 1,506 38,805 -- Investment (loss) income, net ........................... (650) 594 1,374 Interest expense ........................................ (41,592) (28,285) (15,244) Minority interest ....................................... (3,135) (1,494) (236) ----------- ----------- ---------- (Loss) income before income tax (benefit) provision . (104,965) 9,519 (24,192) Income tax (benefit) provision .......................... (23,129) 12,733 (5,402) ----------- ----------- ---------- (Loss) income from continuing operations ............ (81,836) (3,214) (18,790) (Loss) income from discontinued operations, net of tax .. (76,936) 61,129 57,700 (Loss) on sale of discontinued operations, net of tax ... (30,839) -- -- ----------- ----------- ---------- Net (loss) income ................................... $ (189,611) $ 57,915 $ 38,910 =========== =========== ========== (Loss) income per share from continuing operations: Basic ........................................... $ (1.30) $ (0.05) $ (0.31) =========== =========== ========== Assuming dilution ............................... $ (1.30) $ (0.05) $ (0.31) =========== =========== ========== Net (loss) earnings per share: Basic ........................................... $ (3.02) $ 0.94 $ 0.64 =========== =========== ========== Assuming dilution ............................... $ (3.02) $ 0.94 $ 0.64 =========== =========== ========== Weighted average number of shares outstanding: Basic ........................................... 62,837 61,742 61,031 =========== =========== ========== Assuming dilution ............................... 62,837 61,742 61,031 =========== =========== ==========
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 39 NOVACARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS)
COMMON SHARES ISSUED STOCK ADDITIONAL ------------------------- ($.01 PAR TREASURY PAID-IN RETAINED COMMON TREASURY VALUE) STOCK CAPITAL EARNINGS --------- --------- --------- --------- ---------- --------- Balance at June 30, 1996 .... 66,091 (3,190) $ 661 $ (23,465) $ 253,918 $ 253,430 Issued in connection with employee benefit plans .... 539 17 5 11 4,284 -- Issued in connection with acquisitions .............. -- 344 -- 2,474 1,713 -- Repurchase of common stock .. -- (2,761) -- (23,935) -- -- Net income .................. -- -- -- -- -- 38,910 --------- --------- --------- --------- --------- --------- Balance at June 30, 1997 .... 66,630 (5,590) 666 (44,915) 259,915 292,340 Issued in connection with employee benefit plans .... 1,305 59 13 465 9,674 -- Issued in connection with acquisitions .............. -- 130 -- 1,032 3,568 -- Net income .................. -- -- -- -- -- 57,915 --------- --------- --------- --------- --------- --------- Balance at June 30, 1998 .... 67,935 (5,401) 679 (43,418) 273,157 350,255 ISSUED IN CONNECTION WITH EMPLOYEE BENEFIT PLANS .... 583 93 7 744 1,249 -- ISSUED IN CONNECTION WITH ACQUISITIONS .............. 43 -- -- -- 197 -- NET (LOSS) .................. -- -- -- -- -- (189,611) --------- --------- --------- --------- --------- --------- BALANCE AT JUNE 30, 1999 .... 68,561 (5,308) $ 686 $ (42,674) $ 274,603 $ 160,644 ========= ========= ========= ========= ========= =========
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 40 NOVACARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
FOR THE YEARS ENDED JUNE 30, ------------------------------------------- 1999 1998 1997 ----------- --------- --------- CASH FLOWS FROM OPERATING ACTIVITIES: Net (loss) income ................................................ $ (189,611) $ 57,915 $ 38,910 Adjustments to reconcile net (loss) income to net cash flows from operating activities of continuing operations: Loss (income) from discontinued operations, net .................. 76,936 (61,129) (57,700) Loss on sale of discontinued operations, net ..................... 30,839 -- -- Depreciation and amortization .................................. 44,924 39,799 28,290 Minority interest .............................................. 3,135 1,494 236 Provision for uncollectible accounts ........................... 42,540 18,287 13,514 Deferred income taxes .......................................... (11,070) 19,633 3,874 Non-cash portion of nonrecurring items ......................... 41,889 (38,805) -- Changes in assets and liabilities, net of effects from acquisitions and dispositions: Accounts and notes receivable ............................... (46,545) (48,412) (37,746) Inventories ................................................. (6,476) (14,377) 2,502 Other current assets ........................................ (2,810) (6,451) (781) Accounts payable and accrued expenses ....................... (48,304) 30,559 3,807 Current income taxes ........................................ (33,180) 1,705 123 Other, net .................................................. (5,182) (887) (1,660) --------- --------- --------- Net cash flows (used in) continuing operations ................ (102,915) (669) (6,631) Net cash flows from discontinued operations ................... 73,277 73,880 53,872 --------- --------- --------- Net cash flows (used in) provided by operating activities ... (29,638) 73,211 47,241 --------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Payments for businesses acquired, net of cash acquired ........... (61,053) (180,558) (164,149) Additions to property and equipment of continuing operations ..... (22,187) (17,894) (14,804) Additions to property and equipment of discontinued operations ... (10,957) (13,221) (7,278) Proceeds from the sale of investments ............................ 17,001 -- -- Other, net ....................................................... 2,849 (2,301) (1,544) --------- --------- --------- Net cash flows used in investing activities ................. (74,347) (213,974) (187,775) --------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from debt and credit arrangements ....................... 429,525 470,640 263,200 Payment of debt and credit arrangements .......................... (337,026) (373,299) (176,174) Proceeds from subsidiary stock issued ............................ 5 45,709 -- Proceeds from common stock issued ................................ 1,998 7,757 3,750 Payment for purchase of treasury stock ........................... -- -- (23,250) --------- --------- --------- Net cash flows provided by financing activities ............. 94,502 150,807 67,526 --------- --------- --------- Net (decrease) increase in cash and cash equivalents ............. (9,483) 10,044 (73,008) Cash and cash equivalents, beginning of year ..................... 32,760 22,716 95,724 --------- --------- --------- Cash and cash equivalents, end of year ........................... $ 23,277 $ 32,760 $ 22,716 ========= ========= =========
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 41 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations: NovaCare, Inc. ("NovaCare" or the "Company") is a national leader in two business segments: outpatient services and employee services. Outpatient services consist of providing outpatient, orthotic and prosthetic ("O&P") and occupational health rehabilitation services through a national network of patient care centers. Employee services are comprehensive, fully integrated outsourcing solutions to human resource issues, including payroll management, workers' compensation, risk management, benefits administration, unemployment services and human resource consulting services, and are generally provided to small and medium-sized businesses. The Company previously operated in a third segment, long-term care services, providing rehabilitation and healthcare consulting services on a contract basis to health care institutions, primarily long-term care facilities. This segment was disposed of on June 1, 1999. Operating Segments: The Company has adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS 131 uses a "management approach" to defining and reporting the activities of operating segments. The management approach defines operating segments along the lines used by management to assess performance and make operating and capital decisions. The adoption of SFAS 131 did not affect the Company's results of operations or financial position, but did affect the disclosure of segment information provided in Note 16. Principles of Consolidation: The Consolidated Financial Statements include the accounts of the Company, its majority-owned subsidiaries and companies effectively controlled through management agreements under the nominee structure. Under the terms of these agreements, the Company has absolute authority to change the nominee for an insignificant amount of consideration, as long as the nominee is duly certified in the state to which the management agreement pertains. Investments in 20% to 50% of the voting interest of affiliates are accounted for using the equity method. All significant intercompany accounts and transactions have been eliminated. The Company recognizes a minority interest in its Consolidated Balance Sheets and Consolidated Statements of Operations for the portion of majority-owned subsidiaries attributable to its minority owners. Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles 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. Cash and Cash Equivalents: The Company considers its holdings of highly liquid debt and money-market instruments to be cash equivalents if the securities mature within 90 days from the date of acquisition. These investments are carried at cost, which approximates fair value. Net Revenues: Net revenues for outpatient services are reported at the net realizable amounts from customers and third-party payers. The Company records revenue under discounted fee-for-service contracts as those services are provided. Revenue for capitation contracts is recorded in the period that beneficiaries are entitled to health care service. The cost of patient care under these arrangements are recorded in the period that the care is provided. The Company's contracts do not obligate it to provide care after the end of the contract period. Net revenues generated directly from Medicare and Medicaid reimbursement programs represented 20%, 11% and 15% of the Company's consolidated net revenues for fiscal 1999, 1998 and 1997, respectively. Fiscal intermediaries determine settlement amounts due to or receivable from Medicare and Medicaid programs. Management believes that adequate provision has been made in the Consolidated Financial Statements for potential adjustments resulting from such determinations. Employee services revenues and related costs of wages, salaries, and employment taxes pertaining to worksite employees are recognized in the period in which the employee performs the service. Because the Company is at risk for all of its direct costs, independently of whether payment is received from its clients, and consistent with industry practice, all amounts billed to clients for gross salaries and wages, related employment taxes, and health care and workers' compensation coverage are recognized as revenue by the Company. In addition to revenues recognized for direct costs, the Company recognizes revenues for amounts charged as service fees. Service fees are recognized as revenues during the period in which service is provided. The Company establishes an allowance for doubtful accounts based on prior experience. Inventories: Inventories consist of customized orthotic and prosthetic merchandise held for sale, work in process and raw materials and are carried at the lower of cost or market. Cost of inventories is determined by the first-in, first-out method. 42 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) Property and Equipment: Property and equipment are stated at cost. Depreciation is provided on a straight-line basis over the estimated useful lives of the assets, which principally range from three to seven years for property and equipment and 30 to 40 years for buildings. Assets under capital leases and leasehold improvements are amortized over the lesser of the lease term or the asset's estimated useful life. Property and equipment also include external and incremental internal costs incurred to develop major business systems. Capitalized software costs are amortized on a straight-line basis over three to five years. The cost of assets retired, sold or otherwise disposed of and the applicable accumulated depreciation are removed from the accounts, and the resultant gain or loss, if any, is reflected in the Consolidated Statements of Operations. Excess Cost of Net Assets Acquired: Assets and liabilities acquired in connection with business combinations accounted for under the purchase method are recorded at their respective fair values. Deferred taxes have been recorded to the extent of the difference between the fair value and the tax basis of the assets acquired and liabilities assumed. The excess of the purchase price over the fair value of net assets acquired, including the recognition of applicable deferred taxes, consists of non-compete agreements, customers lists, assembled workforce and goodwill and is amortized on a straight-line basis over the estimated useful lives of the assets which range from five to 40 years. Impairment of Long-Lived Assets: Effective July 1, 1997, the Company adopted SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of," which establishes accounting standards for the impairment of long-lived assets, certain identified intangible assets and goodwill related to those assets to be held and used and for long-lived assets and certain intangible assets to be disposed of. In accordance with SFAS No. 121, the Company reviews the realizability of long-lived assets, certain intangible assets and goodwill whenever events or circumstances occur which indicate recorded cost may not be recoverable. The Company also reviews the overall recoverability of goodwill based primarily on estimated future undiscounted cash flows. If the expected future cash flows (undiscounted) are less than the carrying amount of such assets, the Company recognizes an impairment loss for the difference between the carrying amount of the assets and their estimated fair value. In estimating future cash flows for determining whether an asset is impaired, and in measuring assets that are impaired, assets are grouped by geographic region because that is the level at which the Company manages and operates the business and that is the lowest level for which individual cash flow data is maintained. Other Assets: At June 30, 1999 other assets consist principally of deferred charges and miscellaneous receivables. At June 30, 1998 other assets consist principally of investments in affordable income housing partnerships, executive savings plan assets and miscellaneous receivables. Investments in affordable income housing partnerships are recorded at cost and are subject to an annual assessment as to carrying value. The executive savings plan is a non-qualified savings plan offered to Company executives. Contributions made to the fund by eligible employees are partially matched by the Company. Withdrawals from the fund by employees are limited to events specified by the plan. Workers' Compensation: The Company is contractually obligated to provide workers' compensation coverage for its employees and co-employees. Co-employees are defined as third-party worksite employees leased by the Company's employee services segment. The Company accomplishes this through a combination of various commercial insurance policies and self insurance programs. The Company records estimated accruals for workers compensation and health care claims, including estimates for incurred but not reported claims, based upon review of the claims activity and past experience. Management believes any differences which may arise between actual settlement of claims and reserves at June 30, 1999 would not have a material impact on the Company's financial position or results of operations. On July 1, 1997, the Company entered into a three-year contract with a commercial insurance company for worker's compensation coverage. Under this program, the Company's outpatient services segment and the long-term care services segment (classified as discontinued operations) worksite employees continue to be covered under a self insurance program. Third-party worksite employees are covered under a fixed cost insurance program, which is subject to certain per incident and aggregate deductibles. Income Taxes: The Company records deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. Net (Loss) Income Per Share: Basic net (loss) income per share ("EPS") is calculated using the weighted average number of common shares outstanding during each period. Net (loss) income per share - assuming dilution, if diluted, is 43 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) calculated using basic EPS adjusted for the effects of stock options, contingently issuable shares under certain acquisition agreements and convertible subordinated debentures. Comprehensive Income: The Company has adopted the provisions of SFAS No. 130, "Reporting Comprehensive Income." SFAS 130 establishes standards for reporting and display of comprehensive income and its components of net income and other comprehensive income in a full set of general-purpose financial statements. Comprehensive income is defined as the total of net income and all other non-owner changes in equity. For fiscal years 1999, 1998 and 1997 the Company's comprehensive income consists of only net income. 2. FINANCIAL RESTRUCTURING PLAN The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As shown in the consolidated financial statements for the year ended June 30, 1999, the Company reported a $189,611 net loss and, as of June 30, 1999, substantially all of the Company's debt is payable in less than one year. Subsequent to June 30, 1999, all amounts outstanding under the revolving credit facility were repaid, primarily from the net proceeds from the O&P sale and amounts available under the revolving credit facility were reduced to $35,000. Additionally, $37,305, the entire outstanding indebtedness of the O&P business, was assumed by the buyer of the business as discussed below. Of the remaining debt, $175,000 of convertible subordinated debentures is due on January 15, 2000. The Company's ability to make its scheduled debt payments when due is dependent on a number of future actions, the outcomes of which are uncertain. As described above, to partially reduce the Company's debt leverage, on July 1, 1999, the Company sold its O&P business to Hanger Orthopedic Group, Inc. ("Hanger") for $445,000, including $408,000 in cash and the assumption of seller notes of $37,000. Of the purchase price, the Company has placed $15,000 in escrow in conjunction with a $94,000 working capital guarantee to Hanger. The final working capital amount is expected to be settled by no later than October 29, 1999. The proceeds from the transaction were used to satisfy the entire balance of the Company's revolving credit facility, with approximately $37,000 remaining after transaction-related costs. These funds have been temporarily invested to satisfy working capital requirements and future maturities of other debt obligations. Net revenues, gross profit and income from operations of the O&P business for fiscal 1999 was $278,820, $67,454 and $41,602, respectively. Subsequent to the O&P sale, the Company's balance sheet remained highly leveraged and management has proposed a financial restructuring plan to its stockholders in a proxy statement dated August 13, 1999, as amended through September 10, 1999. A special meeting of the Company's stockholders is to be held on September 21, 1999 (the "Special Meeting") to consider and vote upon proposals to approve: (i) the sale of the Company's outpatient physical therapy and occupational health rehabilitation services business (the "PROH Sale"), (ii) the sale of the Company's interest in NovaCare Employee Services, Inc. (the "NCES Sale") and (iii) the adoption of a restructuring proposal. On September 8, 1999, the Company entered into a definitive agreement, subject to certain conditions, to tender its 64% (67% as of June 30, 1999) ownership interest in the outstanding stock of NCES at the price of $2.50 per share, or an aggregate amount of $48,500. The agreement was reached in conjunction with a definitive agreement by NCES to sell NCES to an investment group comprising Patricof & Co. Ventures, Fidelity Ventures Limited and AFLAC Incorporated (the "Investors"). Under the terms of the agreement by NCES, a new private company, established by the Investors, will acquire all the stock of NCES at a price of $2.50 per share of common stock. The Investors intend to effect the purchase through a cash tender offer to NCES stockholders, which will commence on September 15, 1999, and a subsequent merger of NCES into a new private company managed by the Investors. The Company's tender offer of its ownership interest in NCES is subject to the Company's stockholders approval at the Special Meeting and the satisfaction of customary closing conditions. The NCES tender offer is expected to close during October 1999. In the event that the stockholders of NovaCare vote in favor of the NCES sale, NovaCare intends to vote all its shares of NCES in favor of a sale of NCES. As the owner of 64% of the outstanding stock of NCES, NovaCare has the ability to approve such a sale under Delaware law. The Company expects to record an insignificant pretax gain on the sale of NCES. The Company is in the process of seeking buyers for its PROH business. While to date no definitive agreement has been entered into with respect to the PROH Sale, the Company is seeking stockholder approval at the Special Meeting to proceed with the sale when a suitable buyer is identified and a definitive agreement is negotiated with such buyer. The consummation of the PROH Sale would 44 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) be subject to the receipt by the Company of not less than $200,000 in cash and assumption of debt, obtaining a fairness opinion from the Company's financial advisors in connection with the sale and approval by the Board of Directors of the Company of the terms of a definitive sale agreement. The Company has estimated that a valuation of $200,000 for PROH will result in a loss of approximately $312,120. Management believes that any increase in purchase price would result in a direct reduction of the loss. The estimated minimum sales price is based on management's analysis of the business and comparable valuations of public and private businesses similar to those of PROH. The amount the Company will ultimately realize could differ materially from the amount assumed by management in estimating the loss on the proposed disposition of the PROH business. If the restructuring proposal is approved at the Special Meeting, the Company intends to seek to reinvest the net proceeds to the Company from the PROH Sale and the NCES Sale, after the payment of the Company's $175,000 convertible subordinated debentures due January 15, 2000 and certain other liabilities, in a new business or businesses. Any such reinvestment would be subject to the further vote and approval of the stockholders of the Company. If the Company is unable, or chooses not, to reinvest any proceeds in a new business or businesses, the Company will liquidate. If either the PROH Sale is not approved by the stockholders or the conditions to the PROH Sale are not met, the Board of Directors will explore the alternatives then available for the future of the Company. Such alternatives include (i) refinancing the convertible subordinated debentures through a combination of private equity and/or public or private debt, which management believes would demand a high interest rate due to the Company's highly leveraged position and, moreover, there is no assurance that such financing could be obtained, and (ii) in the event the $200,000 sale price condition is not met, seeking to obtain stockholder approval of a sale of PROH at a lower price. In the event that the NCES Sale is not approved by the stockholders or the closing conditions are not met, the Board of Directors will explore the alternatives then available to the Company. Such alternatives include (i) negotiate the NCES Sale with another buyer, (ii) distribute the Company's interest in NCES to NovaCare stockholders pro-rata as a dividend, and (iii) pay existing indebtedness of the Company with shares of NCES's stock (provided such stock is valued at not less than $2.50 per share). If the stockholders do not approve the restructuring proposal, the Company's Board of Directors will explore the alternatives then available for the future of the Company, including (i) presenting a new investment opportunity to stockholders or (ii) liquidating the Company. If the $175,000 convertible subordinated debentures cannot be paid due to the Company's inability to (i) obtain stockholder approval of the PROH sale, (ii) meet the conditions of the PROH sale or (iii) secure refinancing in the event PROH is not sold, the alternatives available to the Company will be limited to (i) a sale of the Company, (ii) negotiating alternative debenture payment terms, including conversion to common stock, and (iii) protection under the Bankruptcy Code. The Company is unable to predict the ultimate outcome of the stockholder vote on these matters or the likelihood of successfully concluding any other available alternative. 3. NET (LOSS) INCOME PER SHARE A reconciliation of (loss) income per share from continuing operations, discontinued operations and on the sale of discontinued operations and net (loss) income per share - all basic and assuming dilution is as follows:
YEARS ENDED JUNE 30, --------------------------------- 1999 1998 1997 ---------- -------- -------- (Loss) income from continuing operations ............................... $ (81,836) $ (3,214) $(18,790) (Loss) income from discontinued operations ............................. (76,936) 61,129 57,700 (Loss) from the sale of discontinued operations ........................ (30,839) -- -- ---------- -------- -------- Net (loss) income ...................................................... $ (189,611) $ 57,915 $ 38,910 ========== ======== ======== Weighted average shares outstanding: Weighted average shares outstanding-- basic and assuming dilution .. 62,837 61,742 61,031 ========== ======== ======== (Loss) income per share from continuing operations: Basic and assuming dilution ........................................ $ (1.30) $ (0.05) $ (.31) ========== ======== ======== (Loss) income per share from discontinued operations, net of tax: Basic and assuming dilution ........................................ $ (1.23) $ 0.99 $ 0.95 ========== ======== ======== (Loss) per share on the sale of discontinued operations, net of tax: Basic and assuming dilution ........................................ $ (0.49) $ -- $ -- ========== ======== ======== Net (loss) income per share: Basic and assuming dilution ........................................ $ (3.02) $ 0.94 $ 0.64 ========== ======== ========
45 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) The Company did not include convertible subordinated debentures, equivalent to 6,567 shares of common stock, options to purchase 2,432, 83, or 1,631 shares in fiscal 1999, 1998 or 1997, respectively, or contingently issuable shares of 41 or 119 in fiscal 1998 or 1997, respectively, because their effects are antidilutive. There were no transactions that occurred subsequent to June 30, 1999 that would have materially changed the number of shares used in computing any of the per share amounts presented. 4. PROVISION FOR RESTRUCTURE - NET During fiscal 1999, the Company's continuing operations reflected provisions for restructure, net totaling $43,295. These provisions were recognized among its operating segments as follows: Outpatient services ................................ $30,225 Employee services .................................. 910 Unallocated selling, general and administrative .... 12,260 ------- Total .............................................. $43,395 =======
The provisions consisted of the following: Write-down of excess cost of net assets acquired, net .. $28,300 Employee severance and related costs ................... 5,431 Lease and technology agreement mitigation costs ........ 8,979 Write-down of property and equipment ................... 685 ------- Total ................................................ $43,395 =======
During fiscal 1999, the Company recorded a provision for restructure of $30,200 in connection with its decision to exit certain non-strategic markets served by its physical rehabilitation and occupational health ("PROH") business within its outpatient services segment. The markets consisted of 40 PROH clinics. This decision resulted in a write-down of the value of the related assets to estimated net realizable value. The provision for restructure consists principally of the write-down of excess cost of net assets acquired, net ($28,300). The clinics to be disposed of had annualized net revenues of approximately $16,600 and annualized operating profit of approximately $200. At June 30, 1999, five of the clinics have been sold for proceeds totaling $923. The net book value of the remaining assets to be sold is approximately $4,991. The Company is reevaluating the decision to dispose of these clinics in light of the proposed PROH sale. As a result of the Company's decision to exit the long-term care services operating segment and sell the O&P business included in its outpatient services segment, the services the Company required of its employee services segment were substantially reduced. The Company's employee services segment recorded a provision for restructure of $910, consisting principally of employee severance costs for 49 employees working at its corporate headquarters and lease mitigation costs, to reflect the impact of this decision. As of June 30, 1999, 32 employees have been terminated related to this charge. Also as a result of the Company's decision to exit the long-term care services operating segment and sell the O&P business, the Company has implemented a program to substantially reduce its unallocated selling, general and administrative costs incurred at its Corporate headquarters. This program (with an aggregate provision of $12,260) involves the termination of 74 employees ($3,060), lease termination cost ($4,800) and equipment and long-term information service agreement buyouts ($4,400). All of these costs are expected to be expended by June 30, 2000. A summary of the activity related to the fiscal 1999 provisions for restructure, net is as follows: Provision for restructure, net .................................. $ 43,395 Less noncash write-down of excess cost of net assets acquired ... (28,300) Less noncash write-down of property and equipment ............... (685) Payments and other reductions ................................... (1,178) -------- Accrued provision for restructure, June 30, 1999 ................ $ 13,232 ========
46 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) 5. DISCONTINUED OPERATIONS During fiscal 1999, the Company experienced a severe decline in revenues and profitability in its long-term care services operating segment. The revenue decline resulted from a combination of reduced patient volume (primarily related to fewer therapy patients per customer facility and fewer treatments per patient) and lower prices. The lower prices in turn reflected reduced reimbursement rates from the Medicare program for contract therapy services. The Company implemented a revised operating model in an attempt to mitigate the effects of the lower reimbursement rates, but continued to experience declining profitability because it could not sufficiently lower its costs to match the decline in revenues. In fiscal 1998, the Company recorded a provision for restructure of $23,500 to recognize the costs of converting to its revised operating model. This provision was recorded based on the anticipated impact of the changes the Medicare reimbursement system mandated by the Balanced Budget Act of 1997 (the "BBA"). The provision related principally to severance costs associated with personnel changes required by the Company's revised operating model and anticipated the severance of approximately 2,975 employees. During fiscal 1999, it became apparent that a portion of this fiscal 1998 charge would not be required. A significant portion of the employee base covered by the restructure reserve voluntarily resigned to seek new employment or obtained employment with customers when these customer facilities converted to in-house therapy programs. Ultimately, 1,441 employees were terminated related to this provision and $13,300 was reversed. In fiscal 1999, the Company recorded a provision for restructure of $111,947 related to its decision to completely exit certain long-term care markets, principally in the Western United States, where it was determined that low customer and therapist concentration would preclude a return to profitability. These markets included California, Colorado, Texas and the Northwest. The Company determined that it would be unable to recover its investment in long-lived assets in the long-term care operating segment and, accordingly, wrote down all of its investment in these assets and recognized the cost, consisting principally of employee severance costs, of exiting the selected markets. The exit plan called for the termination of approximately 1,300 employees, of which 1,200 were direct care providers in the geographic regions exited and the remainder were general and administrative personnel. As of June 30, 1999, 1,198 of the affected employees have been terminated. The provisions for restructure for the long-term care services segment consisted of the following:
YEARS ENDED JUNE 30, ------------------------ 1999 1998 -------- -------- Write-down of excess cost of net assets acquired, net .. $ 73,716 $ -- Write-down of property and equipment ................... 20,748 360 Employee severance and other ........................... 17,483 23,140 Reversal of prior year provision ....................... (13,300) -- -------- -------- Total .................................................. $ 98,647 $ 23,500 ======== ========
A summary of the activity related to the fiscal 1999 and 1998 provisions for restructure for the long-term care services operating segment is as following:
YEARS ENDED JUNE 30, -------------------------- 1999 1998 --------- --------- Beginning balance .................................. $ 22,348 $ -- Provision for restructure .......................... 111,947 23,500 Reversal of prior year provision for restructure ... (13,300) -- Less non-cash portion, principally asset write-offs ...................................... (94,464) (360) Payments and other reductions ...................... (23,325) (792) --------- --------- Ending balance ..................................... $ 3,206 $ 22,348 ========= =========
In spite of these actions, the Company determined that its remaining operations were unlikely to achieve a sufficient level of profitability to justify continued operations. Accordingly, the Company sold its remaining 47 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) long-term care operations to Chance Murphy, Inc. as of June 1, 1999 for a nominal amount and issued a working capital guarantee of $30,000 to the buyer. The Company's hospital contracting business, which is immaterial, previously classified in the Company's long-term care services segment disclosure was not transferred as part of the sale. The Company has restated its prior Consolidated Financial Statements to present the operating results of the long-term care services segment as a discontinued operation. A provision for loss on discontinued operations has been recorded based on management's best estimates of the amounts expected to be realized on the sale of the long-term care services operations. While management's estimates are based on an analysis of the sale transaction, the amounts the Company will ultimately realize could differ materially from the amounts assumed in computing the loss anticipated on the final disposal of the discontinued operations. In connection with the sale of the long-term care services segment, the Company recognized a pretax loss of $36,676 ($30,839 after-tax) which included the $30,000 working capital guarantee and the write down of certain property and equipment and other assets. Results of operations for the long-term care services operating segment consisted of the following:
YEARS ENDED JUNE 30, ------------------------------------------ 1999 1998 1997 --------- --------- --------- Net revenues ....................... $ 351,128 $ 634,534 $ 549,526 (Loss) income before income taxes .. (84,616) 90,027 90,993 Income tax (benefit) provision ..... (7,680) 28,898 33,293 Net (loss) income .................. $ (76,936) $ 61,129 $ 57,700
Net assets of discontinued operations consist of the following:
AS OF JUNE 30, -------------------------- 1999 1998 --------- --------- Accounts receivable from closed operations, net ........................................ $ 13,660 $ 150,422 Accounts receivable from sold operation, net ... 42,702 -- Property and equipment, net .................... -- 19,414 Excess cost of net assets acquired, net ........ -- 75,446 Deferred income tax assets ..................... -- 12,792 Other receivables .............................. 21,906 9,021 Other assets ................................... 4,421 9,128 Accounts payable and accrued expenses .......... (9,501) (47,441) Working capital guarantee ...................... (28,800) -- Deferred income tax liabilities ................ -- (11,896) --------- --------- Total .......................................... $ 44,388 $ 216,886 ========= =========
Other receivables consist of amounts due from customers related to the Company's indemnification of the customer for disallowed Medicare charges. 6. GAIN FROM ISSUANCE OF SUBSIDIARY STOCK In fiscal 1998, NCES completed an initial public offering, converted its manditorily redeemable common stock, and issued common stock to former owners of acquired businesses. In fiscal 1999, NCES issued additional common stock to former owners of acquired businesses. As a result of these common stock transactions, the Company's percentage ownership of NCES decreased to 66.7% at June 30, 1999 from 70.9% and 98.7% at June 30, 1998 and 1997, respectively. The initial public offering included 5,750 shares of NCES common stock issued at $9.00 per share. Proceeds received by NCES, net of underwriting costs, were $45,709. In fiscal 1999 and 1998, the Company recorded pretax gains of $1,506 and $38,805 ($1,506 and $22,895 after-tax, respectively), representing the difference between the Company's historical cost of its investment in NCES and its portion of NCES equity. 48 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) 7. ACQUISITION AND JOINT VENTURE TRANSACTIONS During the year ended June 30, 1999, the Company acquired four outpatient services businesses consisting of one PROH business and three O&P businesses; and two employee services businesses. During the year ended June 30, 1998, the Company acquired 90 outpatient services businesses consisting of 48 PROH and 42 O&P businesses; and two employee services businesses. The following unaudited pro forma consolidated results of operations of the Company give effect to each of the acquisitions as if they occurred on July 1, 1997:
YEARS ENDED JUNE 30, ---------------------------------- 1999 1998 ------------- ------------- Net revenues ................................. $ 1,487,391 $ 1,243,906 (Loss) income from continuing operations...... (81,697) 2,420 (Loss) income from continuing operations per share-basic and assuming dilution..... $ (1.30) $ 0.04
The above pro forma information is not necessarily indicative of the results of operations that would have occurred had the acquisition been made as of July 1, 1997, or the results that may occur in the future. Information with respect to businesses acquired in purchase transactions is as follows (the allocation for fiscal 1999 acquisitions is preliminary):
AS OF JUNE 30, -------------------------- 1999 1998 --------- --------- Excess cost of net assets acquired ... $ 805,710 $ 745,473 Less: accumulated amortization ....... (75,763) (53,190) --------- --------- $ 729,947 $ 692,283 ========= =========
YEARS ENDED JUNE 30, -------------------------- 1999 1998 --------- --------- Cash paid (net of cash acquired) ...................... $ 46,067 $ 146,643 Deferred purchase price obligations ................... 600 4,600 Notes issued .......................................... 4,825 50,754 Closing costs & other ................................. 1,689 9,528 Subsidiary stock issued................................ 4,200 7,590 --------- --------- 57,964 219,115 Liabilities assumed ................................... 4,423 26,724 --------- --------- 61,804 245,839 Fair value of assets acquired, principally accounts receivable and property and equipment ............... (4,900) (43,247) --------- --------- Cost in excess of fair value of net assets acquired ... $ 56,904 $ 202,592 ========= =========
Certain purchase agreements require additional payments if specific financial targets and non-financial conditions are met. The Company records the contingent consideration as an addition to purchase price when the conditions of the contingency are met. Aggregate contingent payments in connection with these acquisitions at June 30, 1999 of approximately $50,794 in cash has not been included in the initial determination of cost of the businesses acquired since the amount of such contingent consideration, if any, is not presently determinable. During the fiscal years ended June 30, 1999, 1998 and 1997, the Company paid $14,986, $33,935 and $15,223, respectively, in cash and issued 43, 130 and 344 shares of common stock, respectively, in connection with businesses acquired in prior years. 49 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) Deferred purchase price obligations represent guaranteed purchase price amounts due to former owners of businesses acquired. Obligations of $14,829 are accrued at June 30, 1999, and are included in accounts payable and accrued expenses. The Company has formed several joint ventures. The carrying value of these investments is $15,120 and $14,881 at June 30, 1999 and 1998, respectively. The Company accounts for investments in joint ventures by the equity method. 8. INVENTORIES Inventories consisted of the following:
AS OF JUNE 30, --------------------- 1999 1998 ------- ------- Materials and supplies .. $28,859 $24,068 Work in process ......... 12,112 10,840 Finished goods .......... 3,680 3,299 ------- ------- $44,651 $38,207 ======= =======
9. PROPERTY AND EQUIPMENT The components of property and equipment were as follows:
AS OF JUNE 30, -------------------------- 1999 1998 --------- --------- Land and buildings ................................ $ 1,779 $ 2,005 Property, equipment and furniture ................. 59,058 60,656 Capitalized software .............................. 33,218 19,155 Leasehold improvements ............................ 28,600 23,239 --------- --------- 122,655 105,055 Less: accumulated depreciation and amortization ... (62,911) (43,612) --------- --------- $ 59,744 $ 61,443 ========= =========
Depreciation and amortization expense, including depreciation of property under capital leases, for fiscal 1999, 1998, and 1997 was $22,058, $21,834 and $17,046, respectively. 10. ACCOUNTS PAYABLE AND ACCRUED EXPENSES Accounts payable and accrued expenses are summarized as follows:
AS OF JUNE 30, ----------------------- 1999 1998 -------- -------- Accounts payable ..................................... $ 19,463 $ 12,806 Accrued compensation and benefits .................... 54,123 72,961 Deferred and contingent purchase price obligations ... 14,829 8,756 Accrued provision for restructure .................... 13,232 -- Accrued workers' compensation and health claims ...... 10,528 24,999 Accrued interest ..................................... 8,042 7,080 Other ................................................ 11,093 18,982 -------- -------- $131,310 $145,584 ======== ========
50 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) 11. FINANCING ARRANGEMENTS Financing arrangements consisted of the following:
AS OF JUNE 30, ----------------------- 1999 1998 -------- -------- Revolving credit facility due December 31, 1999 ....... $347,000 $227,500 Convertible subordinated debentures (5.5%), due January 15, 2000 .................................... 175,000 175,000 Subordinated promissory notes (5% to 10%), payable through 2007 ........................................ 78,584 98,318 $25,000 revolving credit facility of subsidiary, due November 17, 2000 ................................... 2,000 -- Other ................................................. 2,973 7,564 -------- -------- 605,557 508,382 Less: current portion ................................. 551,320 32,074 -------- -------- $ 54,237 $476,308 ======== ========
The Company has a revolving credit facility with a syndicate of lenders that is collateralized by substantially all of the common stock of the Company's subsidiaries and accounts receivable. The maximum amount available at June 30, 1999 was $400,000. The terms of the facility were amended during fiscal 1999 to shorten the maturity date from June 30, 2003 to December 31, 1999 and to change the interest rate from the London Interbank Offered Rate ("LIBOR") plus a range of 0.875% to 1.5%, depending on certain financial ratios, to LIBOR plus 3% (weighted average rate 8.77% at June 30, 1999). The Company has accounted for the payment to amend the revolving credit facility agreement, which decreased the borrowing capacity of the Company, as interest expense. The Company records the charges related to commitment fees as interest expense in the period the commitment was received. The Company is also charged a commitment fee of .50% on the average daily available balance. The weighted average interest rate of the facility during fiscal 1999 was 7.1%. The entire amount of the facility outstanding at June 30, 1999 was repaid on July 1, 1999 from the proceeds of the O&P sale. Subsequent to such repayment, the maximum amount available under the facility was reduced to $35,000 and the financial covenants were removed. The amount available under the facility is further reduced by outstanding letters of credit, which were $1,087 at June 30, 1999. NCES has a revolving credit facility with a syndicate of lenders that is collateralized by a pledge of (i) NCES's subsidiaries' common stock, (ii) the assets of NCES and its subsidiaries, and (iii) the Company's interest in the common stock of NCES. The facility carries an interest rate, depending on certain financial ratios, equal to (i) LIBOR plus a range of 1.375% to 2.5% or (ii) the lead lending bank's prime rate plus a range of 0.125% to 1.25% (7.75% at June 30, 1999). As of June 30, 1999, $23,000 was available under the facility. The weighted average interest rate of the facility during fiscal 1999 was 7.7%. The Company has issued $175,000 of convertible subordinated debentures due January 15, 2000 priced at par to yield 5.5%. The debentures are convertible, at the option of the holder, into shares of the Company's common stock at a conversion price of $26.65 per share. The debentures are redeemable, in whole or in part, at the option of the Company. There is no sinking fund applicable to the debentures. The fair value of the convertible subordinated debentures, based on quoted market prices at June 30, 1999 and 1998, was $161,219 and $166,700, respectively. The estimated fair value of all other debt and financing arrangements approximates carrying value. 51 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) At June 30, 1999, aggregate annual maturities of financing arrangements were as follows for the next five fiscal years and thereafter:
FISCAL YEAR - ----------- 2000 ........... $551,320 2001 ........... 23,422 2002 ........... 17,863 2003 ........... 8,585 2004 ........... 1,746 Thereafter ..... 2,621 -------- $605,557 ========
Interest paid on debt during fiscal 1999, 1998 and 1997 amounted to $36,692, $21,676 and $18,120, respectively. 12. OPERATING LEASES The Company rents office space and equipment under non-cancelable operating leases. In an effort to leverage its purchasing power with lessors, the Company has leased, and concurrently subleased, office space to companies that are controlled by the Company's Chairman. The Company is fully reimbursed for its lease costs for this office space under non-cancelable sublease agreements. Total rent expense charged to operations was $47,882, $37,850 and $27,141 in fiscal 1999, 1998 and 1997, respectively. Future minimum lease payments for all non-cancelable leases as of June 30, 1999 are as follows:
FISCAL YEAR OPERATING LEASES SUBLEASES - ----------- ---------------- --------- 2000 ............... $ 39,026 $ 395 2001 ............... 30,381 253 2002 ............... 23,723 127 2003 ............... 15,274 44 2004 ............... 6,649 -- Thereafter ......... 7,408 -- -------- -------- Total .............. $122,461 $ 819 ======== ========
13. INCOME TAXES The components of income tax expense were as follows:
YEARS ENDED JUNE 30, ---------------------------------------- 1999 1998 1997 -------- -------- -------- Current: Federal ..... $(18,632) $ (9,653) $(10,075) State ....... 6,573 2,752 799 -------- -------- -------- (12,059) (6,901) (9,276) -------- -------- -------- Deferred: Federal ..... (7,610) 15,280 3,016 State ....... (3,460) 4,354 858 -------- -------- -------- (11,070) 19,634 3,874 -------- -------- -------- $(23,129) $ 12,733 $ (5,402) ======== ======== ========
52 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) The components of net deferred tax assets (liabilities) as of June 30, 1999 and 1998 were as follows:
AS OF JUNE 30, ------------------------ 1999 1998 -------- -------- Accruals and reserves not currently deductible for tax purposes ...................................... $ 3,521 $ 4,321 Restructure reserves .................................... 13,584 285 Net operating loss and tax credit carryforwards ......... 49,020 -- Other ................................................... -- 68 -------- -------- Gross deferred tax assets ............................... 66,125 4,674 Valuation allowance ..................................... (27,034) -- -------- -------- Net deferred tax assets ............................. 39,091 4,674 -------- -------- Expenses capitalized for financial statement purposes ... (18,249) (13,104) Depreciation and capital leases ......................... (239) (238) Gain from issuance of subsidiary stock .................. (14,109) (15,600) Other, net .............................................. (6,494) (229) -------- -------- Gross deferred tax liabilities ........................ (39,091) (29,171) -------- -------- Net deferred tax asset (liability) .................... $ -- $(24,497) ======== ========
The Company has recorded a valuation allowance to reflect the estimated amount of deferred tax assets which relate to Federal and state net operating loss carry forwards, in excess of amounts carried back to prior years, and tax credit carryforwards that may not be realized. The change in the valuation allowance for the fiscal year ended June 30, 1999, is as follows: Balance at beginning of year ......................................... $ -- Increase related to deferred tax assets for net operating loss and tax credits which may not be realized .............................. (27,034) -------- Balance at end of year ............................................... $(27,034) ========
The Company has available net operating loss carryforwards of approximately $82,857 for tax purposes to offset future taxable income. The net operating loss carryforwards expire principally in 2018. The Company has $1,500 of alternative minimum tax credits that have no expiration and $2,520 of low income housing credits which expire in 2018. 53 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) The reconciliation of the expected tax (benefit) expense (computed by applying the federal statutory tax rate to income before income taxes) to actual tax (benefit) expense was as follows:
YEARS ENDED JUNE 30, ---------------------------------------- 1999 1998 1997 -------- -------- -------- Expected federal income tax expense (benefit) ................. $(36,738) $ 3,332 $ (8,331) State income taxes, less federal benefit .............. 2,023 4,618 1,077 Dividend exclusion and non-taxable interest income ....... -- -- 59 Non-deductible nonrecurring items .. 259 383 235 Non-deductible amortization of excess cost of net assets acquired .......................... 8,914 3,751 2,325 Federal valuation allowance ........ 1,500 -- -- Other, net ......................... 913 649 (767) -------- -------- -------- $(23,129) $ 12,733 $ (5,402) ======== ======== ========
Income taxes paid during fiscal 1999, 1998 and 1997 amounted to $8,325, $15,359 and $21,981, respectively. 14. MINORITY INTEREST Minority interest resulted from investments in the following entities:
AS OF JUNE 30, --------------------- 1999 1998 ------- ------- NovaCare Employee Services, Inc ... $28,173 $17,863 All other entities ................ 252 443 ------- ------- $28,425 $18,306 ======= =======
During fiscal 1999 and 1998, NCES issued equity instruments on its own behalf. The Company recognizes a minority interest liability for NCES equity issued to third-party investors plus the portion of NCES net income attributable to those investors. 15. BENEFIT PLANS Stock Option Plans: The Company's stock option plans, as amended, provide for issuance of options to purchase up to 8,600 shares of common stock to employees, officers and directors. Under the plans, substantially all options are granted for a term of up to 10 years at prices equal to the fair market value at the date of grant and vest ratably over five years. 54 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) The following summarizes the activity of the stock option plans:
YEARS ENDED JUNE 30, ----------------------------------------------------- 1999 1998 1997 ---------------- ---------------- --------------- Options: Outstanding at beginning of year........ 2,783 2,900 3,188 Granted................................. 4,260 1,020 551 Exercised............................... (17) (881) (364) Canceled................................ (2,596) (256) (475) ---------------- ---------------- --------------- Outstanding at end of year.............. 4,430 2,783 2,900 ================ ================ =============== Option price per share ranges: Outstanding at beginning of year........ $ .12 -- $20.58 $ .09 -- $20.58 $ .09 -- $20.58 Granted................................. 1.25 -- 11.50 12.94 -- 13.56 7.38 -- 13.38 Exercised............................... .12 -- 7.19 .09 -- 14.25 .09 -- 10.63 Canceled................................ .12 -- 20.58 .09 -- 16.50 2.00 -- 16.50 Outstanding at end of year.............. $ .12 -- $20.58 $ .12 -- $20.58 $ .09 -- $20.58 Options exercisable at end of year........ 1,007 1,074 1,464 Exercisable option price ranges........... $ .12 -- $20.58 $ .12 -- $20.58 $ .09 -- $20.58 Options available for grant at end of year under stock option plans........... 419 267 1,034
Other Stock Awards: During 1997, the President of the Company was granted 850 options to purchase the Company's common stock at an exercise price equal to the fair market value on the grant date. The following summarizes the other stock award activity:
YEARS ENDED JUNE 30, ------------------------------------------------------- 1999 1998 1997 ---------------- ---------------- ---------------- Options: Outstanding at beginning of year.... 4,100 4,404 3,554 Granted............................. 150 -- 850 Exercised........................... -- (304) -- Canceled............................ -- -- -- ---------------- ---------------- ---------------- Outstanding at end of year.......... 4,250 4,100 4,404 ================ ================ ================ Option price per share: Outstanding at beginning of year.... $ 4.88 -- $10.88 $ 2.25 -- $10.88 $ 2.25 -- $ 6.88 Granted............................. 11.50 -- 10.88 Exercised........................... -- 2.25 -- 6.88 -- Canceled............................ -- -- -- Outstanding at end of year.......... $ 4.88 -- $11.50 $ 2.25 -- $10.88 $ 2.25 -- $10.88 Options exercisable at end of year.... 2,950 2,800 2,254 Exercisable option price ranges....... $ 4.88 -- $10.88 $ 4.88 -- $10.88 $ 2.25 -- $10.88
55 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) The Company has adopted the disclosure-only provisions of SFAS 123, "Accounting for Stock-Based Compensation" and applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for the plans. The table below sets forth the pro forma information as if the Company had adopted the compensation recognition provisions of SFAS 123:
YEARS ENDED JUNE 30, ---------------------------- 1999 1998 1997 ------ ------ ------ Increase/decrease to: Net loss/net income ..................... $1,654 $2,794 $5,268 Net loss/net income per share-basic ..... .03 .05 .09 Net loss/net income per share-assuming dilution .............................. $ .03 $ .05 $ .09 Assumptions: Expected life (years) ................... 4.0 4.0 4.0 Risk-free interest rate ................. 4.63% 5.92% 6.53% Volatility .............................. 66.00% 37.00% 44.00% Dividend yield .......................... N/A N/A N/A
The weighted average fair value of the stock options, calculated using the Black-Scholes option pricing model, granted during the fiscal years ended June 30, 1999, 1998 and 1997 is $1.66, $4.93 and $4.54, respectively. The remaining contractual life of all options granted as of June 30, 1999 is 6.73 years. Retirement Plans: The Company has defined contribution 401(k) plans covering substantially all of its employees. Company contributions for fiscal 1999, 1998 and 1997 were $5,193, $4,508 and $3,916, respectively. The Company established a non-qualified supplemental benefit plan covering certain key employees. The Company's matching contributions were $845, $859 and $224 for fiscal 1999, 1998 and 1997, respectively. 16. OPERATING SEGMENTS The accounting policies of the Company's operating segments are the same as those described in Note 1, Nature of Operations. Intrasegment revenue relates to the provision of services by the employee services segment to the outpatient and discontinued long-term care segments. The Company evaluates the performance of its segments and allocates resources to them based on income from operations and earnings before interest, income taxes, depreciation and amortization and provision for restructure ("EBITDA"). EBITDA is not a measure of performance under Generally Accepted Accounting Principles ("GAAP"). While EBITDA should not be considered in isolation or as a substitute for net income, cash flows from operating activities and other income or cash flow statement data prepared in accordance with GAAP, or as a measure of profitability or liquidity, management understands that EBITDA is customarily used as a criterion in evaluating health care companies. The Company does not allocate investment income, interest expense, gain on sale of subsidiary stock or minority interest for management reporting purposes. Unallocated assets consist principally of cash and cash equivalents, deferred income taxes, property and equipment and other assets. 56 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) Operating results and other financial data are presented for the principal operating segments of the Company as follows:
YEARS ENDED JUNE 30, ------------------------------------------------- 1999 1998 1997 ----------- ----------- ----------- NET REVENUES: Outpatient services ............................. $ 618,782 $ 535,282 $ 378,021 Employee services ............................... 1,544,622 1,271,757 394,193 ----------- ----------- ----------- Total ................................... 2,163,404 1,807,039 772,214 Intrasegment elimination -- employee services ... (685,487) (769,468) (255,289) ----------- ----------- ----------- Consolidated net revenues .................... $ 1,477,917 $ 1,037,571 $ 516,925 =========== =========== =========== GROSS PROFIT: Outpatient services ............................. $ 182,753 $ 163,750 $ 111,465 Employee services ............................... 64,001 41,547 12,238 Intrasegment elimination -- employee services ... (26,641) (16,646) (5,712) ----------- ----------- ----------- Total ................................... 220,113 188,651 117,991 Depreciation .................................... (9,687) (8,498) (6,422) ----------- ----------- ----------- Consolidated gross profit .................... $ 210,426 $ 180,153 $ 111,569 =========== =========== =========== (LOSS) INCOME FROM OPERATIONS: Outpatient services ............................. $ 47,113 $ 68,000 $ 47,551 Employee services ............................... 17,951 10,898 2,931 ----------- ----------- ----------- Total ................................... 65,064 78,898 50,482 Unallocated selling, general and administrative expenses ...................... (82,763) (78,999) (60,568) Provision for restructure ....................... (43,395) -- -- ----------- ----------- ----------- Consolidated (loss) from operations .......... $ (61,094) $ (101) $ (10,086) =========== =========== =========== DEPRECIATION AND AMORTIZATION: Outpatient services ............................. $ 32,269 $ 25,976 $ 18,018 Employee services ............................... 5,252 3,828 1,286 ----------- ----------- ----------- Total ................................... 37,521 29,804 19,304 Unallocated selling, general and administrative expenses ...................... 7,403 9,995 8,986 ----------- ----------- ----------- Consolidated depreciation and amortization ... $ 44,924 $ 39,799 $ 28,290 =========== =========== =========== EBITDA: Outpatient services ............................. $ 79,382 $ 93,976 $ 65,569 Employee services ............................... 23,203 14,726 4,217 ----------- ----------- ----------- Total ................................... 102,585 108,702 69,786 Unallocated selling, general and administrative expenses ...................... (75,360) (69,004) (51,582) ----------- ----------- ----------- Consolidated EBITDA .......................... $ 27,225 $ 39,698 $ 18,204 =========== =========== =========== CAPITAL EXPENDITURES: Outpatient services ............................. $ 19,117 $ 15,110 $ 14,445 Employee services ............................... 3,070 2,784 359 ----------- ----------- ----------- Total capital expenditures ................... $ 22,187 $ 17,894 $ 14,804 =========== =========== =========== ASSETS: Outpatient services ............................. $ 945,648 $ 913,880 $ 639,461 Employee services ............................... 130,896 112,584 69,719 Unallocated assets .............................. 83,933 53,355 46,918 Net assets of discontinued operations ........... 44,388 216,886 221,822 ----------- ----------- ----------- Total assets ............................ $ 1,204,865 $ 1,296,705 $ 977,920 =========== =========== ===========
57 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) 17. COMMITMENTS AND CONTINGENCIES The Company is subject to legal proceedings and claims which arise in the ordinary course of its business. In the opinion of management, the amount of ultimate liability, if any, with respect to these actions will not have a materially adverse effect on the financial position or results of operations of the Company. The Company's PEO's operations are subject to numerous Federal, state and local laws related to employment, taxes and benefit plan matters. Generally, these regulations affect all companies in the United States. However, the regulatory environment for PEOs is an evolving area due to uncertainties resulting from the non-traditional employment relationship created by PEOs. Many Federal and state laws relating to tax and employment matters were enacted prior to the development of PEO companies and do not specifically address the obligations and responsibilities of these co-employer relationships. The Internal Revenue Service ("IRS") has conducted a market segment study of the PEO industry (the "Market Segment Study") focusing on selected PEOs (not including the Company) for the purpose of examining the relationship among PEOs, their clients, worksite employees, and the worksite owners. IRS officials indicate that the Market Segment Study is near completion and suggest that an announcement of the IRS' position with respect to PEOs has been delayed pending the outcome of legislation that has been proposed by the PEO industry. If the IRS concludes that PEOs are not "employers" of certain worksite employees for purposes of the Internal Revenue Code, the Company's benefit plans (including cafeteria, health and welfare, and retirement plans) may lose their favorable tax status, and the Company may no longer be able to assume its clients' Federal employment tax withholding obligations. The Company believes that, although unfavorable to the Company, a prospective application by the IRS of an adverse conclusion would not have a material adverse effect on the Company's business, financial position, results of operations and liquidity. While the Company believes that a retrospective disqualification is unlikely, there can be no assurance as to the ultimate resolution of these issues. 18. SHAREHOLDER RIGHTS PLAN Under the terms of a Shareholder Rights Plan adopted in 1995, the Company's Board of Directors declared a dividend distribution of one right for each outstanding common share. The rights may not be exercised or traded apart from the common shares to which they are attached until 10 days after a person or group has acquired, obtained the right to acquire, or commenced a tender offer for, at least 20% of the Company's outstanding common shares. In such event, each right will become exercisable for one common share for a price of $27. If a person or group acquires, or obtains the right to acquire, 20% or more of the Company's outstanding common shares, each right will become exercisable for common shares worth $54 and the rights held by the acquiror will become null and void. If the Company is involved in a merger and its common shares are changed or exchanged, or if more than 50% of its assets or earnings power is sold or transferred, each right will become exercisable for common stock of the acquiror worth $54. The rights will expire on March 20, 2000 unless earlier redeemed by the Company for $.001 per right. Subject to its right to extend the redemption period, the Company may redeem the rights at any time until any person or group has acquired, or obtained the right to acquire, at least 20% of the Company's outstanding common shares. 19. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
FOURTH THIRD SECOND FIRST QUARTER QUARTER QUARTER QUARTER ---------- ---------- ---------- ---------- YEAR ENDED JUNE 30,1999: Net revenues...................................... $ 396,504 $ 373,503 $ 366,249 $ 341,661 Gross profit...................................... 55,052 49,980 52,677 52,717 (Loss) income from continuing operations.......... (29,434) (10,633) (36,414) (5,355) (Loss) income from discontinued operations, net of tax...................................... (4,471) (101,409) 17,916 11,028 (Loss) on sale of discontinued operations, net of tax...................................... (30,839) -- -- -- Net (loss) income................................. (64,744) (112,042) (18,498) 5,673 (Loss) per share from continuing operations - basic and assuming dilution........ $ (0.47) $ (0.17) $ (0.58) $ (0.09) (Loss) income per share from discontinued operations, net of tax.......................... $ (0.07) $ (1.61) $ 0.29 $ 0.18 (Loss) per share on the sale of discontinued operations, net of tax.......................... $ (0.49) $ -- $ -- $ -- Net (loss) income per share - basic and assuming dilution........................... $ (1.03) $ (1.78) $ (0.29) $ 0.09 YEAR ENDED JUNE 30,1998: Net revenues....................................... $ 310,740 $ 281,147 $ 239,494 $ 206,190 Gross profit....................................... 55,499 44,114 41,719 38,821 (Loss) income from continuing operations........... (2,848) (9,550) 12,835 (3,651) Income from discontinued operations, net of tax.... 17,322 22,195 7,737 13,875 Net (loss) income.................................. 14,474 12,645 20,572 10,224 (Loss) income per share from continuing operations -- basic and assuming dilution........ $ (0.05) $ (0.16) $ 0.21 $ (0.06) (Loss) income per share from discontinued operations, net of tax........................... $ 0.28 $ 0.37 $ 0.12 $ 0.23 Net income per share -- basic and assuming dilution................................ $ 0.23 $ 0.21 $ 0.33 $ 0.17
Results for all interim periods presented have been restated to reclassify the Company's long-term care services segment to discontinued operations. 58 NOVACARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) JUNE 30, 1999 (IN THOUSANDS, EXCEPT PER SHARE DATA) Results for the fourth quarter of fiscal 1999 include a $12,260 pretax provision for restructure related primarily to the consolidation and reorganization of the Company's corporate support services activities, a $15,340 pretax provision for bad debts related to certain receivables determined by management to be uncollectible and a $30,839 after-tax loss on sale of discontinued operations. Results for the third quarter of fiscal 1999 include an $111,947 pretax provision for restructure within discontinued operations related to the exit of certain long-term care markets. Results for the second quarter of fiscal 1999 include a $31,100 pretax provision for restructure related to the exit of certain PROH markets and a $13,300 reversal of a portion of a previously established restructure charge within discontinued operations related to the conversion to the Company's revised long-term care operating model. Results for the second quarter of fiscal 1998 include a $23,500 pretax provision for restructure within discontinued operations related to the conversion to the Company's revised long-term care operating model. 59 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of NovaCare, Inc. In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) on page 69 present fairly, in all material respects, the financial position of NovaCare, Inc. and its subsidiaries at June 30, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 1999, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule listed in the index appearing under item 14(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2, "Financial Restructuring Plan", to the financial statements, the Company has $175 million of convertible subordinated debentures due on January 15, 2000. To enable the Company to generate sufficient funds to make the required payment on the convertible debentures, the Board of Directors on August 5, 1999 voted to seek approval from the shareholders for the sale of the Company's two remaining business units (the outpatient physical rehabilitation and occupational health rehabilitation services business, and the Company's interest in NovaCare Employee Services, Inc.) and the adoption of a restructuring proposal. In a proxy statement dated August 13, 1999 (as amended through September 10, 1999) the Company's shareholders have been asked to consider and vote upon these proposals at a special meeting of the shareholders to be held on September 21, 1999. Adoption of these proposals could result in the ultimate liquidation of the Company. Should these matters not be approved, or should the transactions not be consummated as set forth in the proxy statement, management would need to seek other means to obtain sufficient funds to repay the convertible debentures when due. The results of the shareholder vote will determine the alternatives available to the Company. These matters raise substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters are described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties. PRICEWATERHOUSECOOPERS LLP Philadelphia, PA August 30, 1999 except for the third and fourth paragraphs of Note 2 as to which the date is September 10, 1999. 60 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES The Registrant has had no changes in or disagreements with accountants on accounting and financial disclosure of the type referred to in Item 304 of Regulation S-K. 61 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The directors and executive officers of NovaCare are as follows:
NAME POSITION AGE ---- -------- --- John H. Foster............................... Chairman of the Board of Directors 57 Timothy E. Foster............................ Chief Executive Officer and Director 47 James W. McLane.............................. President, Chief Operating Officer and Director 60 E. Martin Gibson............................. Director 61 Siri S. Marshall............................. Director 51 Stephen E. O'Neil............................ Director 66 George W. Siguler............................ Director 52 Daniel C. Tosteson........................... Director 74 Robert E. Healy, Jr.......................... Senior Vice President, Finance and Administration and Chief Financial Officer 46 Steven M. Wise............................... Senior Vice President, Information Systems and Chief Information Officer 43 Richard S. Binstein.......................... Vice President, General Counsel and Secretary 38 Susan J. Campbell............................ Vice President, Investor Relations 48 Richard A. McDonald.......................... Vice President and Treasurer 52 Barry E. Smith............................... Vice President, Controller and Chief Accounting Officer 46 James T. Walmsley............................ Vice President, Reimbursement 49
No family relationships exist among any of the directors or executive officers of NovaCare. Executive officers serve at the discretion of the NovaCare Board of Directors. JOHN H. FOSTER has been Chairman of the Board of NovaCare since December 1984. From 1984 to May 1997, he was also Chief Executive Officer of the Company. He is a director of NovaCare Employee Services, Inc., ("NCES"), the Company's 64% owned subsidiary. Mr. Foster is also Chairman of the Board and Chief Executive Officer of Integra, Inc., a national behavioral health services company, Chairman of the Board of XYAN, Inc., an internet-based digital imaging company, and a director of Corning Incorporated, an international corporation with business interests in specialty materials and communications, Mr. Foster is founder and Chairman of the Board of Foster Management Company, an investment advisor. TIMOTHY E. FOSTER has been Chief Executive Officer of the Company since May 1997. From October 1994 until May 1997, he was President and Chief Operating Officer. He served as Senior Vice President, Finance and Administration and Chief Financial Officer of NovaCare from November 1988 to October 1994, Treasurer from March 1992 to October 1994, Secretary of the Company from September 1987 to May 1994 and has been a director since December 1984. Mr. Foster currently serves as a director of Integra, Inc., a national behavioral health services company, a position he has held since February 1995, as well as a director of NCES. Since 1996, Mr. Foster has been a partner in certain investment partnerships managed by Foster Management Company. JAMES W. McLANE has been President and Chief Operating Officer and a director of the Company since May 1997. From 1991 to 1997, Mr. McLane served as Chief Executive Officer of Aetna Health Plans and as Executive Vice President of Aetna Life and Casualty. E. MARTIN GIBSON has been a director of the Company since March 1992. Mr. Gibson, who is retired, served as Chairman and Chief Executive Officer of Corning Lab Services, Inc., a subsidiary of Corning Incorporated, from 1990 until December 1994. He currently serves as a director of IT Group, Inc., an environmental management company, Hardinge Brothers, Inc., a manufacturer of machine tools, and Sensus Corp., a private biotechnology company, and as the Chairman of the Board of NCES. 62 SIRI S. MARSHALL has been a director of the Company since May 1994. Ms. Marshall is Senior Vice President, Corporate Affairs and General Counsel of General Mills, Inc., a food manufacturing company. She joined General Mills in 1994 from Avon Products, Inc. where she was Senior Vice President, General Counsel and Secretary. She is a Director of Jafra Cosmetics International and The American Arbitration Association, and a Trustee of the Minneapolis Institute of Arts. STEPHEN E. O'NEIL has been a director of the Company since December 1984. Mr. O'Neil has been a Principal of The O'Neil Group, a private investment firm, since 1981. He is a director of Brown-Forman Corporation, Castle Convertible Fund, Inc., Spectra Fund, Inc., Alger Fund, Inc., Alger American Fund and NCES. GEORGE W. SIGULER has been a director of the Company since September 1986. Since January 1996, he has been a managing director of Siguler Guff & Company, LLC, an investment management firm. From September 1991 to January 1996, Mr. Siguler was a managing director of Mitchell Hutchins Institutional Investors Inc. Mr. Siguler is a director of Business Mortgage Investors, Inc. and Commonfund Capital, Inc. DANIEL C. TOSTESON, M.D., has been a director of the Company since April 1991. He is Dean Emeritus of the Faculty of Medicine and Caroline Shields Walker Distinguished Professor of Cell Biology, Harvard University. From 1977 to 1997, Dr. Tosteson was Dean of the Faculty of Medicine and Caroline Shields Walker Professor of Cell Biology, Harvard University and President of Harvard Medical Center. Dr. Tosteson has been President of the American Academy of Arts and Sciences since 1997 and was a Member of the Board of Trustees of Duke University from 1987 until 1995. ROBERT E. HEALY, JR. has been Senior Vice President, Finance and Administration and Chief Financial Officer since December 1995. From January 1994 to December 1995, he was Vice President, Finance and Chief Financial Officer of NovaCare's Long-term Care Services segment. He served as Vice President, Finance and Chief Accounting Officer of the Company from March 1992 to January 1994. STEVEN M. WISE has been Senior Vice President, Information Systems and Chief Information Officer since January 1998. He was Vice President, Information Systems and Chief Information Officer from December 1995 to January 1998. He joined NovaCare in 1993 as Director, Systems and Programming, for the Contract Rehabilitation Division. RICHARD S. BINSTEIN has been Vice President, General Counsel and Secretary since January 1999. From February 1998 through January 1999, he was Vice President, Acting General Counsel and Secretary. He joined NovaCare in January 1997 as Assistant General Counsel. Prior to joining the Company, he was a practicing attorney with the law firm of Proskauer Rose. SUSAN J. CAMPBELL has been Vice President, Investor Relations of NovaCare since April 1992. She joined NovaCare in March 1993 as Director of Investor Relations and also served as Vice President, Communications from April 1995 to March 1998. RICHARD A. McDONALD has been Vice President and Treasurer since August 1996 and was Director, Treasury Services from May 1995 until August 1996. Prior to joining the Company, he was a financial consultant to Continental Medical Systems, Inc. He served as an assistant treasurer with American Healthcare Management from 1990 until 1994. BARRY E. SMITH has been Vice President, Controller and Chief Accounting Officer of the Company since December 1995 and was Vice President of Finance of the Long-term Care Services segment from March 1995 to October 1997. He was Vice President of Finance of the Medical Rehabilitation Hospital Division from February 1994 through the sale date of the division in April 1995. JAMES T. WALMSLEY has been Vice President, Reimbursement of NovaCare since January 1994 and was Director of Reimbursement from April 1992 to January 1994. 63 ITEM 11. EXECUTIVE COMPENSATION The following table sets forth information for the fiscal years ended June 30, 1999, 1998 and 1997 concerning the compensation paid or awarded to the Chief Executive Officer and each of the four other most highly compensated executive officers of the Company. SUMMARY COMPENSATION TABLE
LONG TERM ANNUAL COMPENSATION COMPENSATION ALL OTHER NAME AND -------------------------------------- AWARDS COMPENSATION PRINCIPAL POSITION YEAR SALARY ($) BONUS ($) OTHER ($) (1) OPTIONS (#) (2) ------------------ ---- ---------- --------- ------------- ------------ ------------ John H. Foster (3) 1999 $300,000 $ - $ 45,135 200,000 $ 94,933 Chairman of the Board 1998 580,266 487,670 128,374 - 100,584 1997 553,899 - 66,627 - 36,303 Timothy E. Foster (4) 1999 500,000 875,000 13,600 400,000 66,526 Chief Executive Officer 1998 500,000 243,835 7,395 - 71,381 1997 495,482 194,550 - 31,091 James W. McLane (5) 1999 465,000 815,000 595 550,000 42,402 President and Chief Operating 1998 457,500 195,068 - - 27,213 Officer 1997 70,274 - 850,000 - Robert E. Healy, Jr. (6) 1999 302,093 570,000 - 320,000 139,916 Senior Vice President and 1998 274,151 180,000 - - 39,726 Chief Financial Officer 1997 212,500 125,373 - - 15,535 Richard S. Binstein (7) 1999 157,500 365,000 - 49,500 48,921 Vice President, General Counsel 1998 120,000 34,905 - - 3,287 and Secretary 1997 55,000 4,611 - - 918
(1) This amount represents the Company's incremental cost of personal use of Company aircraft, after deducting payments received by the Company for such use. (2) Other than the loan forgiveness of $25,000 in 1999 for Richard Binstein and payments to Mr. Binstein and Robert E. Healy, Jr. of $12,500 and $96,509, respectively, for the cancellation of certain outstanding stock options in 1999, these amounts represent contributions to the Company's 401(k) plan and its supplemental deferred compensation plan and term life and long-term disability insurance payments. (3) John H. Foster served as Chairman of the Board and Chief Executive Officer of the Company until May 1997, when he relinquished the position of Chief Executive Officer. (4) Timothy E. Foster became Chief Executive Officer of the Company in May 1997. From October 1994 to May 1997, he was President and Chief Operating Officer of the Company. Prior to such time he served as Senior Vice President - Finance and Administration, Chief Financial Officer and Treasurer of the Company. (5) James W. McLane became President and Chief Operating Officer in May 1997. (6) Robert E. Healy, Jr. became Senior Vice President, Finance and Administration and Chief Financial Officer in December 1995. Prior to such time he served as Vice President, Finance and Chief Financial Officer of the Company's Long-term Care Services segment. (7) Richard S. Binstein became Vice President, General Counsel and Secretary in January 1999. Mr. Binstein joined the Company in January 1997 as Assistant General Counsel. 64 The following table sets forth the number and value of options exercised by the executive officers of the Company named in the Summary Compensation Table during the fiscal year ended June 30, 1999 and the number and value of options held by such executive officers at June 30, 1999. AGGREGATED OPTION EXERCISES IN FISCAL YEAR 1999 AND FISCAL YEAR-END OPTION VALUES
NUMBER OF SECURITIES VALUE OF UNDERLYING UNEXERCISED UNEXERCISED IN-THE-MONEY OPTIONS AT OPTIONS JUNE 30, 1999(#) AT JUNE 30, 1999($)(1) --------------------- ---------------------- NAME SHARES ACQUIRED VALUE EXERCISABLE/ EXERCISABLE/ ---- UPON EXERCISE REALIZED UNEXERCISABLE UNEXERCISABLE --------------- -------- --------------------- ---------------------- John H. Foster - - 1,650,001 / 599,999 - Timothy E. Foster - - 900,001 / 699,999 - James W. McLane - - 400,000 / 1,000,000 - Robert E. Healy, Jr. - - 61,237 / 245,931 - Richard S. Binstein - - 0 / 49,500 -
(1) In-the-money options are those for which the fair market value of the underlying Common Stock exceeds the exercise price of the option. The value of in-the-money options is determined in accordance with regulations of the Securities and Exchange Commission by subtracting the aggregate exercise price of the option from the aggregate year-end value of the underlying Common Stock. EMPLOYMENT AGREEMENTS In July 1994, the Company entered into an employment agreement with John H. Foster, Chairman of the Board of the Company. The agreement was amended on February 2, 1995, July 1, 1998, September 1, 1998 and May 30, 1999. The term of the agreement expires on June 30, 2000 and the agreement provides for automatic one-year extensions commencing one year prior to termination in June 2000 and continuing on each subsequent anniversary until either party shall give the other notice of non-extension. The agreement provides for Mr. Foster to receive an annual base salary, currently $300,000, subject to increases in accordance with the policies of the Company, and to be eligible for an annual cash bonus opportunity equal to 100% of base salary. In the event of Mr. Foster's death, disability or voluntary termination, he shall be entitled to pro-rated bonus compensation for the fiscal year during which such event occurs. The agreement also provides that if Mr. Foster is terminated by the Company without cause, or if Mr. Foster resigns subsequent to a change in control of the Company, a material diminution of his position, authority or compensation or his removal by the Company as Chairman of the Board, then Mr. Foster shall be entitled to (i) severance pay in the form of salary continuation at a rate equal to the greater of his then annual salary or $580,000 and certain other benefits for a period of two years from the date of such event, and (ii) bonus compensation in an amount equal to (a) the greater of 100% of his then annual salary or $580,000, prorated for the year in which such termination occurs, plus (b) a final bonus equal to the greater of $870,000 or 150% of his then annual base salary. The agreement also provides that if Mr. Foster resigns subsequent to a change in control of the Company, amounts otherwise payable to Mr. Foster under his agreement shall be reduced by amounts paid to him as salary for the period from and after July 1, 1999 and shall be further reduced to the extent, if any, necessary so that no payment is treated as an "excess parachute payment" under the Internal Revenue Code of 1986, as amended. The agreement also provides that Mr. Foster shall be entitled to the advance of certain expenses in connection with legal proceedings arising in connection with his service as an officer or director of the Company and certain other benefits. 65 In May 1999, the Company entered into employment agreements, described below, with Timothy E. Foster, a director and the Chief Executive Officer of the Company, James W. McLane, a director and the President and Chief Operating Officer of the Company, Robert E. Healy, Jr., a Senior Vice President and the Chief Financial Officer of the Company, and Richard S. Binstein, Vice President, General Counsel and Secretary of the Company (collectively, the "May 1999 Employment Agreements"), superseding prior employment agreements between each such executive and the Company. Pursuant to certain "change of control" and constructive termination provisions in such prior employment agreements, upon the completion of the Company's sale of the LTC and O&P businesses (and resulting restructuring and/or reorganization), Messrs. Foster, McLane and Healy contractually may have had the right to terminate their employment with the Company and to receive substantial severance payments. In order to induce these key senior executives to waive their right to trigger such termination provisions and to satisfy the requirements of the Company's senior lenders, all of the Company's outside directors, upon the recommendation of the Compensation Committee of the Board of Directors, unanimously approved the May 1999 Employment Agreements, which contain certain signing, transaction and retention bonus payments based, in part, on the execution of the transactions outlined in the Company's Proxy Statement, dated August 13, 1999. The signing, transaction and retention bonus payments contained in the May 1999 Employment Agreements are in lieu of severance. On May 30, 1999, the Company entered into an employment agreement with Timothy E. Foster, Chief Executive Officer of the Company, superseding Mr. Foster's then existing employment agreement with the Company. The term of the agreement continues through July 1, 2001. Upon execution of the agreement, Mr. Foster received a signing bonus of $875,000, which amount (net of taxes) must be repaid to the Company by Mr. Foster if he voluntarily terminates his employment with the Company prior to January 1, 2000. The agreement provides for Mr. Foster to receive an annual base salary, currently $500,000, subject to increases as determined by the Compensation Committee of the Board of Directors, and to be eligible for certain transaction and retention bonuses. The transaction bonuses set forth in the agreement are as follows: (i) a transaction bonus equal to $475,000 payable upon the sale or other disposition of the Company's interest in NCES, and (ii) a transaction bonus equal to $400,000 upon the sale of the Company's Physical Rehabilitation and Occupational Health ("PROH") business (or the earlier repayment of the Company's Subordinated Debentures, under certain circumstances). The retention bonuses set forth in the agreement are as follows: (i) a retention bonus equal to $500,000 payable on January 2, 2000, provided Mr. Foster is then employed by the Company and (ii) a retention bonus equal to $500,000 payable on the earlier of June 30, 2000 or the date the Company implements a plan of liquidation (provided the PROH sale has been completed). In addition, if Mr. Foster's employment with the Company continues beyond June 30, 2000, the agreement provides for additional retention bonuses to be paid to Mr. Foster, in an amount equal to $500,000, on each January 2 and June 30 thereafter, provided that Mr. Foster is then employed by the Company. Under the agreement, Mr. Foster is not eligible for any additional stock option grants. The agreement also provides that if Mr. Foster is terminated by the Company without cause, then Mr. Foster shall be entitled to payment of the aforementioned transaction bonuses (if then unpaid) and payment of a pro rata portion of the aforementioned retention bonuses, as well as continuation of his rights and benefits under the Company's benefit plans and programs for a two year period following such termination of employment. The agreement also provides that Mr. Foster shall be entitled to the advance of certain expenses in connection with legal proceedings arising in connection with his service as an officer or director of the Company and certain other benefits. On May 30, 1999, the Company entered into an employment agreement with James W. McLane, President and Chief Operating Officer of the Company, superseding Mr. McLane's then existing employment agreement with the Company. The term of the agreement continues through July 1, 2001. Upon execution of the agreement, Mr. McLane received a signing bonus of $815,000, which amount (net of taxes) must be repaid to the Company by Mr. McLane if he voluntarily terminates his employment with the Company prior to January 1, 2000. The agreement provides for Mr. McLane to receive an annual base salary, currently $465,000, subject to increases as determined by the Compensation Committee of the Board of Directors, and to be eligible for certain transaction and retention bonuses. The transaction bonuses set forth in the agreement are as follows: (i) a transaction bonus equal to $362,500 payable upon the sale or other disposition of the Company's interest in NCES, and (ii) a transaction bonus equal to $450,000 upon the sale of the PROH business (or the earlier repayment of the Company's Subordinated Debentures, under certain circumstances). The retention bonuses set forth in the agreement are as follows: (i) a retention bonus equal to $350,000 payable on January 2, 2000, provided Mr. McLane is then employed by the Company and (ii) a retention bonus equal to $350,000 payable on the earlier of June 30, 2000 or the date the Company sells the PROH business. In addition, if Mr. McLane's employment with the Company continues beyond June 30, 2000, the agreement provides for additional retention bonuses to be paid to Mr. McLane, in an amount equal to $350,000, on each January 2 and June 30 thereafter, provided that Mr. McLane is then employed by the Company. Under the agreement, Mr. McLane is not eligible for any additional stock option grants. The agreement also provides that if Mr. McLane is terminated by the Company without cause, then Mr. McLane shall be entitled to payment of the aforementioned transaction bonuses (if then unpaid) and payment of a pro rata portion of the aforementioned retention bonuses, as well as continuation of his rights and 66 benefits under the Company's benefit plans and programs for a two year period following such termination of employment. The agreement also provides that Mr. McLane shall be entitled to the advance of certain expenses in connection with legal proceedings arising in connection with his service as an officer or director of the Company and certain other benefits. On May 30, 1999, the Company entered into an employment agreement with Robert E. Healy, Jr., Senior Vice President, Finance and Administration and Chief Financial Officer of the Company, superseding Mr. Healy's then existing employment agreement with the Company. The term of the agreement continues through July 1, 2001. Upon execution of the agreement, Mr. Healy received a signing bonus of $570,000, which amount (net of taxes) must be repaid to the Company by Mr. Healy if he voluntarily terminates his employment with the Company prior to January 1, 2000. The agreement provides for Mr. Healy to receive an annual base salary, currently $325,000, subject to increases as determined by the Compensation Committee of the Board of Directors, and to be eligible for certain transaction and retention bonuses. The transaction bonuses set forth in the agreement are as follows: (i) a transaction bonus equal to $317,500 payable upon the sale or other disposition of the Company's interest in NCES, and (ii) a transaction bonus equal to $250,000 upon the sale of the PROH business (or the earlier repayment of the Company's Subordinated Debentures, under certain circumstances). The retention bonuses set forth in the agreement are as follows: (i) a retention bonus equal to $245,000 payable on January 2, 2000, provided Mr. Healy is then employed by the Company and (ii) a retention bonus equal to $245,000 payable on the earlier of June 30, 2000 or the date the Company implements a plan of liquidation (provided the PROH sale has been completed). In addition, if Mr. Healy's employment with the Company continues beyond June 30, 2000, the agreement provides for additional retention bonuses to be paid to Mr. Healy, in an amount equal to $245,000, on each January 2 and June 30 thereafter, provided that Mr. Healy is then employed by the Company. Under the agreement, Mr. Healy is not eligible for any additional stock option grants. The agreement also provides that if Mr. Healy is terminated by the Company without cause, then Mr. Healy shall be entitled to payment of the aforementioned transaction bonuses (if then unpaid) and payment of a pro rata portion of the aforementioned retention bonuses, as well as continuation of his rights and benefits under the Company's benefit plans and programs for a two year period following such termination of employment. The agreement also provides that Mr. Healy shall be entitled to the advance of certain expenses in connection with legal proceedings arising in connection with his service as an officer or director of the Company and certain other benefits. On May 30, 1999, the Company entered into an employment agreement with Richard S. Binstein, Vice President, General Counsel and Secretary of the Company, superceding Mr. Binstein's then existing employment agreement with the Company. The term of the agreement continues through July 1, 2001. Upon execution of the agreement, Mr. Binstein received a signing bonus of $335,000, which amount (net of taxes) must be repaid to the Company by Mr. Binstein if he voluntarily terminates his employment with the Company prior to January 1, 2000. The agreement provides for Mr. Binstein to receive an annual base salary, currently $190,000, subject to increases as determined by the Compensation Committee of the Board of Directors, and to be eligible for certain transaction and retention bonuses. The transaction bonuses set forth in the agreement are as follows: (i) a transaction bonus equal to $180,000 payable upon the sale or other disposition of the Company's interest in NCES, and (ii) a transaction bonus equal to $150,000 upon the sale of the Company's PROH business (or the earlier repayment of the Company's Subordinated Debentures, under certain circumstances). The retention bonuses set forth in the agreement are as follows: (i) a retention bonus equal to $145,000 payable on January 2, 2000, provided Mr. Binstein is then employed by the Company and (ii) a retention bonus equal to $145,000 payable on the earlier of June 30, 2000 or the date the Company implements a plan of liquidation (provided the PROH sale has been completed). In addition, if Mr. Binstein's employment with the Company continues beyond June 30, 2000, the agreement provides for additional retention bonuses to be paid to Mr. Binstein, in an amount equal to $145,000, on each January 2 and June 30 thereafter, provided that Mr. Binstein is then employed by the Company. Under the agreement, Mr. Binstein is not eligible for any additional stock option grants. The agreement also provides that if Mr. Binstein is terminated by the Company without cause, then Mr. Binstein shall be entitled to payment of the aforementioned transaction bonuses (if then unpaid) and payment of a pro rata portion of the aforementioned retention bonuses, as well as continuation of his rights and benefits under the Company's benefit plans and programs for a two year period following such termination of employment. The agreement also provides that Mr. Binstein shall be entitled to the advance of certain expenses in connection with legal proceedings arising in connection with his service as an officer or director of the Company and certain other benefits. COMPENSATION OF DIRECTORS OF NOVACARE The Company provides each non-employee director with an annual retainer of $25,000. The Company pays each director a fee of $1,000 per meeting attended, plus out-of-pocket expenses. In addition, committee members receive a fee of $1,000, plus out-of-pocket expenses, for each non-telephonic committee meeting attended that is not scheduled in conjunction with a meeting of the full Board, and a fee of $500, plus out-of-pocket expenses, for each non-telephonic committee meeting attended in conjunction with a 67 meeting of the full Board and for each telephonic meeting of the Board or any committee of the Board. As part of the compensation paid to non-employee directors for the fiscal year ended June 30, 1999, the Company granted to each non-employee director options to purchase 15,000 shares of the Company's Common Stock. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION E. Martin Gibson, as Chairman, Stephen E. O'Neil and Siri S. Marshall served on the Compensation Committee of the Board of Directors for the entire 1999 fiscal year. No insider served on the Committee and there were no interlocks. 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS The following table shows the number of shares and percentage of the Company's outstanding Common Stock deemed to be beneficially owned as of June 30, 1999, by (i) all persons known to the Company to be the beneficial owners of more than 5% of its common stock, (ii) each director of the Company and (iii) the directors and officers of the Company as a group. Unless otherwise indicated, the beneficial owners have sole voting and investment power with respect to all shares owned.
Name of Beneficial Owner (a) Amount and Nature of Percentage of - ---------------------------- Beneficial Ownership Outstanding Shares --------------------- ------------------ John H. Foster .................................................... 4,151,214 (b) 5.9% Timothy E. Foster ................................................. 900,001 (c) 1.3% E. Martin Gibson .................................................. 50,000 (d) * Siri S. Marshall .................................................. 39,200 (e) * James W. McLane ................................................... 437,504 (f) * Stephen E. O'Neil ................................................. 47,500 (g) * George W. Siguler ................................................. 51,400 (h) * Daniel C. Tosteson ................................................ 53,400 (i) * Directors and Officers as a group (16 persons) .................... 5,893,261 (j) 8.2%
* Less than one percent (a) Information as to the interests of the directors and officers has been furnished in part by them. The inclusion of information concerning shares held by or for their spouses or children or by corporations in which they have an interest does not constitute an admission by such persons of beneficial ownership thereof. Unless otherwise indicated, all persons have sole voting and dispositive power as to all shares they are shown as owning. (b) Includes 1,650,001 shares of the Company's Common Stock presently issuable upon the exercise of options. Mr. John Foster beneficially owns 8,000 shares of NCES Common Stock presently issuable upon exercise of options. (c) Consists of 900,001 shares of the Company's Common Stock presently issuable upon the exercise of options. In addition, Mr. Timothy Foster owns 18,000 shares of NCES Common Stock, 8,000 of such shares presently issuable upon exercise of options. 68 (d) Includes 47,400 shares of the Company's Common Stock presently issuable upon the exercise of options. In addition, Mr. Gibson owns 41,667 shares of NCES Common Stock, 26,667 of such shares presently issuable upon exercise of options. (e) Includes 37,200 shares of the Company's Common Stock presently issuable upon the exercise of options. In addition, Ms. Marshall owns 6,667 shares of NCES Common Stock presently issuable upon exercise of options. (f) Includes 430,000 shares of the Company's Common Stock presently issuable upon the exercise of options, and 7,504 shares of the Company's Common Stock issuable upon the conversion of the Debentures. In addition, Mr. McLane owns 12,000 shares of NCES Common Stock, 2,000 of such shares presently issuable upon exercise of options. (g) Includes 47,400 shares of the Company's Common Stock presently issuable upon the exercise of options. In addition, Mr. O'Neil owns 13,334 shares of NCES Common Stock presently issuable upon exercise of options. (h) Includes of 47,400 shares of the Company's Common Stock presently issuable upon the exercise of options. In addition, Mr. Siguler owns 6,667 shares of NCES Common Stock presently issuable upon exercise of options. (i) Consists of 53,400 shares of the Company's Common Stock presently issuable upon the exercise of options. In addition, Mr. Tosteson owns 6,667 shares of NCES Common Stock presently issuable upon exercise of options. (j) Includes 3,359,993 shares of the Company's Common Stock presently issuable upon exercise of options. In addition, officers and directors own 130,552 shares of NCES Common Stock, 93,002 of such shares presently issuable upon exercise of options. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Since January 1993, the Company has subleased office space to certain companies controlled by John H. Foster, Chairman of the Board of the Company, in his capacity as chairman of the board, chief executive officer or general partner of the principal stockholders of such companies. The Company paid base rent at an annual rate of $14.00 per square foot through December 1997 and $17.50 per square foot from January 1998 through December 2003. The companies controlled by Mr. Foster will pay base rent at a rate equal to the Company's cost, including reimbursement for leasehold improvements made by the Company, through December 2003 for their respective areas under sublease as follows: Foster Management Company, 5,728 square feet; and Integra, Inc., 6,760 square feet. Timothy E. Foster, Chief Executive Officer and a director of the Company, serves as a director of Integra, Inc, a company controlled by John H. Foster. In the ordinary course of business, the Company purchases printing and copying related services from XYAN, Inc., a national internet-based digital imaging company controlled by John H. Foster, Chairman of the Board of the Company, in his capacity as chairman of the board of, and general partner of various venture capital investment funds that own interests in, that company. The negotiated rates paid by the Company to XYAN, Inc. for these services were determined at arms-length. During the fiscal years ended June 30, 1998 and 1999, the Company paid XYAN, Inc. approximately $1,850,000 and $1,150,000, respectively, for services provided. In addition, as of September 1999, the Company had a prepaid balance of $510,000, representing a prepayment for services made by the Company to XYAN, Inc. in exchange for preferential national pricing. The Company is currently applying all charges for services provided by XYAN, Inc. against the prepaid balance and expects to fully realize the prepaid balance in the fiscal year ending June 30, 2000. 69 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report:
PAGE NUMBER ------ (1) FINANCIAL STATEMENTS: Consolidated Balance Sheets at June 30, 1999 and 1998........................ 37 Consolidated Statements of Operations for each of the three years in the period ended June 30, 1999...................................... 38 Consolidated Statements of Changes in Shareholders' Equity for each of the three years in the period ended June 30, 1999.................... 39 Consolidated Statements of Cash Flows for each of the three years in the period ended June 30, 1999...................................... 40 Notes to Consolidated Financial Statements................................... 41-58 Report of Independent Accountants............................................ 59 (2) FINANCIAL STATEMENT SCHEDULES: II -- Valuation and Qualifying Accounts for each of the three years in the period ended June 30, 1999...................................... 71 (3) EXHIBITS (NUMBERED IN ACCORDANCE WITH ITEM 601 OF REGULATION S-K): The exhibits required to be filed are listed in the index to exhibits
(b) Current Reports on Form 8-K: On April 7, 1999, the Company filed a Current Report on Form 8-K dated April 2, 1999 with the Securities and Exchange Commission reporting information under Item 5, Other Events. On June 16, 1999, the Company filed a Current Report on Form 8-K dated June 1, 1999 with the Securities and Exchange Commission reporting the sale of the Company's long-term care services business under Item 2, Acquisition or Disposition of Assets. On June 30, 1999, the Company filed Form 8-K/A as an amendment to the Current Report filed June 16, 1999 on Form 8-K. 70 POWER OF ATTORNEY The Registrant and each person whose signature appears below hereby appoint John H. Foster and Timothy E. Foster as attorneys-in-fact with full power of substitution, severally, to execute in the name and on behalf of the Registrant and each such person, individually and in each capacity stated below, one or more amendments to the annual report which amendments may make such changes in the report as the attorney-in-fact acting in the premises deems appropriate and to file any such amendment to the report with the Securities and Exchange Commission. --------------- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. NOVACARE, INC. By: ---------------------------------- (ROBERT E. HEALY, JR., SENIOR VICE PRESIDENT, FINANCE AND ADMINISTRATION AND CHIEF FINANCIAL OFFICER) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE --------- ----- ---- /S/ JOHN H. FOSTER Chairman of the Board and Director September 20, 1999 -------------------------------- (JOHN H. FOSTER) /S/ TIMOTHY E. FOSTER Chief Executive Officer and Director September 20, 1999 -------------------------------- (TIMOTHY E. FOSTER) /S/ JAMES W. MCLANE President, Chief Operating Officer September 20, 1999 -------------------------------- and Director (JAMES W. MCLANE) /S/ ROBERT E. HEALY, JR. Senior Vice President, Finance and September 20, 1999 -------------------------------- Administration and Chief Financial (ROBERT E. HEALY, JR.) Officer /S/ BARRY E. SMITH Vice President, Controller and Chief September 20, 1999 -------------------------------- Accounting Officer (BARRY E. SMITH) /S/ E. MARTIN GIBSON Director September 20, 1999 -------------------------------- (E. MARTIN GIBSON) /S/ SIRI S. MARSHALL Director September 20, 1999 -------------------------------- (SIRI S. MARSHALL) /S/ STEPHEN E. O'NEIL Director September 20, 1999 -------------------------------- (STEPHEN E. O'NEIL) /S/ GEORGE W. SIGULER Director September 20, 1999 -------------------------------- (GEORGE W. SIGULER) /S/ DANIEL C. TOSTESON, M.D. Director September 20, 1999 -------------------------------- (DANIEL C. TOSTESON, M.D.)
71 SCHEDULE II NOVACARE, INC. VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED JUNE 30, 1999, 1998 AND 1997 (IN THOUSANDS)
BALANCE AT CHARGED TO BALANCE BEGINNING COSTS AND AT END DESCRIPTION OF PERIOD EXPENSES OTHER DEDUCTIONS OF PERIOD - -------------------------------------- ---------- ---------- ---------- ---------- ---------- Year ended June 30, 1999: Allowance for uncollectible accounts $ 35,550 42,540 86 (1) (41,580) $ 38,459 1,863 (2) Year ended June 30, 1998: Allowance for uncollectible accounts $ 17,170 18,287 8,127 (1) (15,247) $ 35,550 7,213 (2) Year ended June 30, 1997 Allowance for uncollectible accounts $ 5,859 13,514 5,010 (1) (10,412) $ 17,170 3,199 (2)
(1) Allowances for doubtful accounts related to acquired receivables. (2) Charged against net revenues. 72 INDEX TO EXHIBITS
EXHIBIT PAGE NUMBER EXHIBIT DESCRIPTION NUMBER - ------- ------------------- ------ 2 (a) (i) Stock Purchase Agreement dated as of April 2, 1999 by and among -- NovaCare, Inc., NC Resources, Inc., Hanger Orthopedic Group, Inc. and HPO Acquisition Corp. (incorporated by reference to Exhibit 2(a) to the Company's Current Report on Form 8-K dated July 1, 1999). (ii) Amendment No. 1 to Stock Purchase Agreement made as of May 19, -- 1999 by and among NovaCare, Inc., NC Resources, Inc., Hanger Orthopedic Group, Inc. and HPO Acquisition Corp. (incorporated by reference to the Exhibit 2 (b) to the Company's Current Report on Form 8-K dated July 1, 1999). (iii) Amendment No. 2 to Stock Purchase Agreement made as of June -- 30, 1999 by and among NovaCare, Inc., NC Resources, Inc., Hanger Orthopedic Group, Inc. and HPO Acquisition Corp. (incorporated by reference to Exhibit 2(c) to the Company's Current Report on Form 8-K dated July 1, 1999). 2 (b) (i) Stock Purchase Agreement dated as of June 1, 1999 by and among -- NovaCare, Inc., NC Resources, Inc. and Chance Murphy, Inc. (incorporated by reference to Exhibit 2(a) to the Company's Current Report on Form 8-K dated June 1, 1999). (ii) Amendment No. 1 to Stock Purchase Agreement made as of June 1, -- 1999 by and among NovaCare, Inc., NC Resources, Inc. and Chance Murphy, Inc. (incorporated by reference to Exhibit 2(b) to the Company's Current Report on Form 8-K dated June 1, 1999). 3 (a)* Certificate of Incorporation of the Company, as amended to date -- (incorporated by reference to Exhibit 3(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992). 3 (b) By-laws of the Company, as amended to date (incorporated by -- reference to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1995). 4 (a) Stock Option Plan, as amended to date (incorporated by reference to -- Exhibit 4(a) to the Company's Annual Report on Form 10-K for the year ended June 30, 1997). 4 (b)* Form of Indenture dated as of January 15, 1993 between the Company -- and Pittsburgh National Bank relating to 51/2% Convertible Subordinated Debentures Due 2000 (incorporated by reference to Exhibit 4 to Registration Statement on Form S-3 No. 33-55710). 4 (c) Rights Agreement dated as of March 9, 1995 by and between NovaCare, -- Inc. and American Stock Transfer & Trust Company, as Rights Agent (incorporated by reference to Exhibit 99(a) to the Company's current report on Form 8-K dated March 14, 1995). 4 (d) 1998 Stock Option Plan (incorporated by reference to Exhibit 4 to -- Registration Statement Form S-8 No. 333-70653). 10 (a) (i) Employment Agreement dated as of October 9, 1996 between the -- Company and Barry E. Smith (incorporated by reference to Exhibit 10(c) to the Company's Quarterly Report on Form 10-Q for the quarter ended December 31, 1997). (ii) Amendment dated as of October 1, 1998 to the Employment -- Agreement dated as of October 9, 1996 between the Company and Barry E. Smith (incorporated by reference to Exhibit 10(h) to the Company's Quarterly
73 Report on Form 10-Q for the quarter ended September 30, 1998). 10 (b) Stock Purchase Agreement dated as of May 1, 1997 between NovaCare -- Employee Services, Inc. and James W. McLane (incorporated by reference to Exhibit 10(i) to the Company's Annual Report on Form 10-K for the year ended June 30, 1998). 10 (c) (i) Employment Agreement dated as of March 18, 1998 between the -- Company and Ronald G. Hiscock (incorporated by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1998). (ii) First Amendment dated as of October 8, 1998 to the Employment -- Agreement dated as of March 18, 1998 between the Company and Ronald G. Hiscock (incorporated by reference to Exhibit 10(f) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998). 10 (d) (i) Amendment No. 2 to the Amended and Restated Employment Agreement dated as of May 30, 1999 between the Company and John H. Foster. (ii) Amended and Restated Employment Agreement dated as of July 1, -- 1998 between the Company and John H. Foster (incorporated by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998). (iii) Amendment dated September 1, 1998 to the Amended and Restated -- Employment Agreement dated as of July 1, 1998 between the Company and John H. Foster (incorporated by reference to Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998). 10 (e) (i) Employment Agreement dated as of May 30, 1999 between the -- Company and Timothy E. Foster (incorporated by reference to Exhibit 10(a) to the Company's Current Report Form 8-K dated July 1, 1999). 10 (f) Employment Agreement dated as of May 30, 1999 between the Company -- and James W. McLane (incorporated by reference to Exhibit 10(b) to the Company's Current Report on Form 8-K dated July 1, 1999). 10 (g) Employment Agreement dated as of May 30, 1999 between the Company -- and Robert E. Healy, Jr. (incorporated by reference to Exhibit 10(c) to the Company's Current Report on Form 8-K dated July 1, 1999). (h) (i) Revolving Credit Facility Agreement dated as of May 27, 1994 by -- and among NovaCare and certain of its subsidiaries and PNC Bank, First Union National Bank of North Carolina, Mellon Bank, N.A., Nations Bank of North Carolina, N.A., CoreStates Bank, N.A., and National Westminster Bank, N.A. (incorporated by reference to Exhibit 10(g) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1994). (ii) Revolving Credit Facility Credit Agreement First Amendment -- dated as of September 20, 1994 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon Bank, N.A., Nations Bank of North Carolina, N.A., CoreStates Bank, N.A., and National Westminster Bank, N.A. (incorporated by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended December 31, 1994). (iii) Revolving Credit Facility Agreement Second Amendment dated as -- of November 28, 1994 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon Bank, N.A., Nations Bank of North Carolina, N.A.,
74 CoreStates Bank, N.A., National Westminster Bank, N.A., and Fleet Bank of Massachusetts, N.A. (incorporated by reference to Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended December 31, 1994). (iv) Revolving Credit Facility Agreement Third Amendment dated as -- of May 15, 1995 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon Bank, N.A., Nationsbank, N.A. (Carolina), CoreStates Bank, N.A., NatWest Bank, N.A., and Fleet Bank of Massachusetts, N.A. (incorporated by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1995). (v) Revolving Credit Facility Agreement Fourth Amendment dated as -- of May 19, 1995 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon Bank, N.A., Nationsbank, N.A. (Carolina), CoreStates Bank, N.A., NatWest Bank, N.A., and Fleet Bank of Massachusetts (incorporated by reference to Exhibit 10 (a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1995). (vi) Revolving Credit Facility Agreement Fifth Amendment dated as -- of June 30, 1996 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon Bank, N.A., Nationsbank, N.A. (Carolina), CoreStates Bank, N.A., and Fleet Bank of Massachusetts (incorporated by reference to Exhibit 10(j) (vi) to the Company's Annual Report on Form 10-K for the year ended June 30, 1996). (vii) Revolving Credit Facility Agreement Sixth Amendment dated as -- of June 30, 1996 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., CoreStates Bank, N.A., First Union National Bank of North Carolina, Fleet Bank of Massachusetts, N.A., Mellon Bank, N.A. and Nationsbank, N.A. (incorporated by reference to Exhibit 10(j)(vii) to the Company's Annual Report on Form 10-K for the year ended June 30, 1996). (viii) Revolving Credit Facility Agreement Seventh Amendment dated -- as of November 4, 1996 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon Bank, N.A., Nationsbank, N.A. (Carolina), CoreStates Bank, N.A., and Fleet Bank of Massachusetts, N.A. (incorporated by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996). (ix) Revolving Credit Facility Agreement Eighth Amendment dated as -- of January 30, 1997 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon Bank, N.A., Nationsbank, N.A., CoreStates Bank, N.A., Fleet Bank of Massachusetts, N.A., The Bank of New York, and SunTrust Bank (Central Florida), N.A. (incorporated by reference to Exhibit (10)(j)(ix) to the Company's Annual Report on Form 10-K for the year ended June 30, 1998). (x) Revolving Credit Facility Agreement Ninth Amendment dated as of -- January 30, 1997 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon Bank, N.A., Nationsbank, N.A., CoreStates Bank, N.A., Fleet Bank of Massachusetts, N.A., The Bank of New York, and SunTrust Bank (Central Florida), N.A. (incorporated by reference to Exhibit 10(j)(x) to the Company's Annual Report on Form 10-K for the
75 year ended June 30, 1998). (xi) Revolving Credit Facility Agreement Tenth Amendment dated as of -- March 31, 1997 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon Bank, N.A., Nationsbank, N.A., CoreStates Bank, N.A., Fleet National Bank, The Bank of New York, and SunTrust Bank (Central Florida), N.A. (incorporated by reference to Exhibit 10(j)(xi) to the Company's Annual Report on Form 10-K for the year ended June 30, 1997). (xii) Revolving Credit Facility Agreement Eleventh Amendment dated -- as of June 27, 1997 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon Bank, N.A., Nationsbank, N.A., CoreStates Bank, N.A., Fleet National Bank, The Bank of New York, SunTrust Bank (Central Florida), N.A., and Bank One (Kentucky), N.A. (incorporated by reference to Exhibit 10(j)(xii) to the Company's Annual Report on Form 10-K for the year ended June 30, 1998). (xiii) Revolving Credit Facility Agreement Twelfth Amendment dated -- as of September 30, 1997 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., First Union National Bank, Mellon Bank, N.A., NationsBank, N.A., Corestates Bank, N.A., Fleet Bank, The Bank of New York, SunTrust Bank (Central Florida) N.A., Bank One (Kentucky) N.A., The Fuji Bank, Limited (New York Branch), Crestar Bank, Bank of Tokyo-Mitsubishi Trust Company, and AmSouth Bank (incorporated by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997). (xiv) Revolving Credit Facility Agreement Thirteenth Amendment dated -- as of November 17, 1997 by and among NovaCare and certain of its subsidiaries and PNC Bank N.A., Corestates Bank, N.A., First Union National Bank, Fleet National Bank, Mellon Bank, N.A., The Bank of New York, SunTrust Bank (Central Florida) N.A., Bank One (Kentucky) N.A., The Fuji Bank, Limited (New York Branch), Crestar Bank, Bank of Tokyo-Mitsubishi Trust Company, AmSouth Bank (incorporated by reference to Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1998). (xv) Revolving Credit Facility Agreement Fourteenth Amendment dated -- as of February 24, 1998 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., Corestates Bank, N.A., First Union National Bank, Fleet National Bank, Mellon Bank, N.A., The Bank of New York, SunTrust Bank (Central Florida) N.A., Bank One (Kentucky) N.A., The Fuji Bank, Limited (New York Branch), Crestar Bank, Bank of Tokyo-Mitsubishi Trust Company, AmSouth Bank (incorporated by reference to Exhibit 10(c) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1998). (xvi) Revolving Credit Facility Agreement Fifteenth Amendment dated -- as of February 27, 1998 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., Corestates Bank, N.A., First Union National Bank, Fleet National Bank, Mellon Bank, N.A., The Bank of New York, SunTrust Bank (Central Florida) N.A., Bank One (Kentucky) N.A., The Fuji Bank, Limited (New York Branch), Crestar Bank, Bank of Tokyo-Mitsubishi Trust Company, AmSouth Bank (incorporated by reference to Exhibit 10(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1998). (xvii) Revolving Credit Facility Agreement Sixteenth Amendment dated as of March 30, 1998 by and among NovaCare and certain of its
76 subsidiaries and PNC Bank, N.A., Corestates Bank, N.A., First Union National Bank, Fleet National Bank, Mellon Bank, N.A., The Bank of New York, SunTrust Bank (Central Florida) N.A., Bank One (Kentucky) N.A., The Fuji Bank, Limited (New York Branch), Crestar Bank, Bank of Tokyo-Mitsubishi Trust Company, AmSouth Bank (incorporated by reference to Exhibit 10(e) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1998). (xviii) Revolving Credit Facility Agreement Seventeenth Amendment -- dated as of June 30, 1998 by and among NovaCare and certain of its subsidiaries and PNC Bank, N.A., First Union National Bank, Fleet National Bank, Mellon Bank, N.A., Nations Bank, N.A., The Bank of New York, SunTrust Bank (Central Florida) N.A., Bank One (Kentucky) N.A., The Fuji Bank, Limited (New York Branch), Crestar Bank, Bank of Tokyo-Mitsubishi Trust Company, AmSouth Bank, Bank of America NT & SA, Comerica Bank, Credit Lyonnais (New York Branch), Cooperative Centrale Raiffersen-Boerenleenbank B.A., "Rabobank Nederaland", (New York Branch), The Tokai Bank, Limited (New York Branch), Toronto Dominion (Texas), Inc. (incorporated by reference to Exhibit 10(i) (xviii) to the Company's Annual Report on Form 10-K for the year ended June 30, 1998). (xix) Revolving Credit Facility Agreement Eighteenth Amendment dated -- as of December 18, 1998 by and among NovaCare and certain of its subsidiaries and PNC Bank N.A., First Union National Bank, Fleet National Bank, Mellon Bank, N.A., Nations Bank, N.A., The Bank of New York, SunTrust Bank (Central Florida) N.A., Bank One (Kentucky) N.A., The Fuji Bank, Limited (New York Branch), Crestar Bank, Bank of Tokyo-Mitsubishi Trust Company, AmSouth Bank, Bank of America NT and SA, Comerica Bank, Credit Lyonnais (New York Branch), Cooperative Centrale Raiffersen- Boerenleenbank B.A., "Rabobank Nederland" (New York Branch), The Tokai Bank, Limited (New York Branch), Toronto Dominion (Texas), Inc. (incorporated by reference top Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999). (xx) Revolving Credit Facility Agreement Nineteenth Amendment dated -- as of March 31, 1999 by and among NovaCare and certain of its subsidiaries and PNC Bank N.A, First Union National Bank, Fleet National Bank, Mellon Bank, N.A., Nations Bank, N.A., The Bank of New York, SunTrust Bank (Central Florida) N.A., Bank One (Kentucky) N.A., The Fuji Bank, Limited (New York Branch), Crestar Bank, Bank of Tokyo-Mitsubishi Trust Company, AmSouth Bank, Bank of America NT and SA, Comerica Bank, Credit Lyonnais (New York Branch), Cooperative Centrale Raiffersen-Boerenleenbank B.A., "Rabobank Nederland" (New York Branch), The Tokai Bank, Limited (New York Branch), Toronto Dominion (Texas), Inc. (incorporated by reference to Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999). (xxi) Revolving Credit Facility Agreement Twentieth Amendment dated -- as of April 19, 1999 by and among NovaCare and certain of its subsidiaries and PNC Bank N.A, First Union National Bank, Fleet National Bank, Mellon Bank, N.A., Nations Bank, N.A., The Bank of New York, SunTrust Bank (Central Florida) N.A., Bank One (Kentucky) N.A., The Fuji Bank, Limited (New York Branch), Crestar Bank, Bank of Tokyo-Mitsubishi Trust Company, AmSouth Bank, Bank of America NT and SA, Comerica Bank, Credit Lyonnais (New York Branch), Cooperative Centrale Raiffersen-Boerenleenbank B.A., "Rabobank Nederland" (New York Branch), The Tokai Bank, Limited (New York Branch), Toronto Dominion (Texas), Inc. (incorporated by reference to Exhibit 10(c) to the Company's Quarterly Report on Form 10-Q for the quarter ended
77 March 31, 1999). (xxii) Revolving Credit Facility Agreement Twenty First Amendment -- dated as of April 19, 1999 by and among NovaCare and certain of its subsidiaries and PNC Bank N.A, First Union National Bank, Fleet National Bank, Mellon Bank, N.A., Nations Bank, N.A., The Bank of New York, SunTrust Bank (Central Florida) N.A., Bank One (Kentucky) N.A., The Fuji Bank, Limited (New York Branch), Crestar Bank, Bank of Tokyo-Mitsubishi Trust Company, AmSouth Bank, Bank of America N.A., Comerica Bank, Credit Lyonnais (New York Branch), Cooperative Centrale Raiffersen-Boerenleenbank B.A., "Rabobank Nederland" (New York Branch), The Tokai Bank, Limited (New York Branch), Toronto Dominion (Texas), Inc. 10 (i) Supplemental Benefits Plan as amended to date (incorporated by -- reference to Exhibit 10(k) to the Company's Annual Report on Form 10-K for the year ended June 30, 1998). 21 Subsidiaries of the Company. -- 23 Consent of Independent Accountants. -- 24 Power of Attorney (see "Power of Attorney" in Form 10-K). -- 27 Financial Data Schedules. --
Copies of the exhibits filed with this Annual Report on Form 10-K or incorporated by reference herein do not accompany copies hereof for distribution to shareholders of the Company. The Company will furnish a copy of any of such exhibits to any stockholder requesting the same. Exhibits denoted by an asterisk were filed prior to the Company's adoption of filing via EDGAR. EX-10.(D)(I) 2 AMENDMENT NO. 2 TO EMPLOYMENT AGREE. DATED 5/30/99 1 AMENDMENT NO. 2 TO AMENDED AND RESTATED EMPLOYMENT AGREEMENT This Amendment No. 2 to the Amended and Restated Employment Agreement (the "Amendment") made as of the 30th day of May, 1999, by and between NovaCare, Inc., a Delaware corporation (the "Company"), and John H. Foster (the "Executive"), W I T N E S S E T H: WHEREAS, the parties have heretofore entered into an Amended and Restated Employment Agreement dated as of July 1, 1998, as amended by Amendment No. 1 thereto dated as of September 1, 1998, (the "Employment Agreement"); and WHEREAS, the parties now wish to amend the Employment Agreement further as hereinafter set forth. NOW, THEREFORE, in consideration of the premises and the mutual agreements hereinafter set forth, the parties hereby agree as follows: 1. Section 6.7 of the Agreement shall be modified to include the following clause at the end of the first sentence thereof: "and further provided that amounts payable to the Executive pursuant to this Section 6.7 shall be reduced by amounts paid as salary to the Executive for the period from and after July 1, 1999; and further provided that amounts payable to the Executive pursuant to this Section 6.7 shall be reduced to the extent, if any, required so that no amounts payable pursuant to this Section 6.7 shall be treated as "excess parachute payments" within the meaning of Section 280G of the Internal Revenue Code of 1986, as amended (it being agreed that the Executive's "base amount" for the period 1994 through 1998 is not less than the amount set forth on Exhibit A)." 2. Section 6.7 of the Agreement shall be further modified to include the following as the final two sentences thereof: "Without limiting the generality of clause (C) of this Section 6.7, substantially all of the business and/or assets of the Company shall be deemed to have been disposed of upon the closing of a sale or other disposition of any Major Operating Business (as hereinafter defined) of the Company if the sale of such Major Operating Business (whether in the form of a sale or other disposition of assets, sale or other disposition of the 2 stock of the corporation(s) operating the Business or a combination thereof) has been approved by the shareholders of the Company or is pursuant to a plan approved by the shareholders of the Company. The term "Major Operating Business" shall include each of the following businesses of the Company: (a) the long-term care services business, (b) the business of NovaCare Employee Services, Inc., (c) the orthotics and prosthetics business, and (d) the physical rehabilitation and occupational health business. 3. In all other respects the Employment Agreement shall remain in full force and effect without change. IN WITNESS WHEREOF, the parties hereto have executed this Amendment as of the date first above written. NOVACARE, INC. By: /s/ Timothy E. Foster --------------------------------- Timothy E. Foster Chief Executive Officer /s/ John H. Foster --------------------------------- John H. Foster 3 Exhibit A Calculation of "Base Amount" under I.R.C. ss. 280G(b)(3)(A) for John H. Foster based on wages and other compensation as shown in Box 1 of Form W-2 issued by NovaCare, Inc.: 1994 $ 827,792 1995 $ 411,846 1996 $1,043,031 1997 $ 747,644 1998 $ 382,090 ---------- Total $3,412,403 Base Amount = 3,412,403 / 5 = 682,480 Base Amount times 3 = (682,480 x 3) = $2,047,440 The Base Amount would be increased by amounts deferred under a 401(k) plan or Section 125 "cafeteria" plan. If the relevant "change of control" occurs after December 31, 1999, the calculation would be based on compensation paid from 1995 through 1999. EX-10.(H)(XXII) 3 REVOLVING CREDIT FACILITY AGREEMENT 21ST AMENDMENT 1 NOVACARE, INC. 1016 WEST NINTH AVENUE KING OF PRUSSIA, PA 19406 Dated as of August 6, 1999 PNC Bank, National Association, as Agent One PNC Plaza 249 Fifth Avenue Pittsburgh, PA 15222-2707 Attn: Frank Taucher, Senior Vice President RE: Twenty-First Amendment to Credit Agreement (the "Twenty-First Amendment") Dear Frank: We refer to that certain Credit Agreement, dated as of May 27, 1994, as amended (the "Credit Agreement"), by and among NovaCare, Inc. ("NovaCare") and certain of its Subsidiaries, the Banks party thereto and PNC Bank, National Association, as agent for the Banks ("Agent"). Defined terms used herein, not otherwise defined herein, shall have the meanings given to them under the Credit Agreement as amended hereby. The parties hereto in consideration of their mutual covenants and agreements hereinafter set forth, and intending to be legally bound hereby, covenant and agree as follows: AGREEMENT 1. Waiver of Certain Provisions of Credit Agreement. The Agent on behalf of the Banks hereby waives the compliance with the provision of Section 2.04 [Voluntary Reduction of Commitment] which requires five (5) Business Days' prior written notice by the Borrowers to the Agent in order for the Borrowers to permanently reduce the Revolving Credit Commitments to $35,000,000 effective on the Twenty-First Amendment Effective Date. 2. Amendments to Credit Agreement. The parties hereto do hereby modify and amend the Credit Agreement as follows: (a) The cover page of the Credit Agreement is hereby amended by deleting in the first line the number "$400,000,000" and inserting in lieu thereof the number "$35,000,000." 2 Recital paragraph 1, page 1, is hereby amended by deleting the number "$400,000,000" and inserting in lieu thereof the number "$35,000,000." (b) Section 1.01 [Certain Definitions] of the Credit Agreement is hereby amended by the deletion of the definition of the term "Annual Permitted Acquisition Amount," and the addition of the following new definitions: "GP Therapy shall mean GP Therapy, L.L.C., a Georgia limited liability corporation." "Twenty-First Amendment Effective Date shall mean as of August 6, 1999 which is the effective date of the Twenty-First Amendment to this Agreement." (c) Subsection (b) of Section 2.01 [Revolving Credit Borrowing; Limitations on Revolving Facility Usage] is hereby deleted in its entirety and the following is inserted in lieu thereof; "(b) During the period commencing on the Twenty-First Amendment Effective Date through and including the Expiration Date, the Borrowers shall not request Revolving Credit Loans or the issuance of Letters of Credit which would result in the Revolving Facility Usage exceeding $35,000,000, and the Banks shall not be obligated to fund any Revolving Credit Loans or to issue any Letter of Credit which would result in the Revolving Facility Usage exceeding $35,000,000. The Borrowers shall make a mandatory repayment of principal, whether or not the Agent has given notice to such effect, in order that the Revolving Facility Usage during any period does not exceed the amount during such period as specified above." (d) Subsection (ix) [Repayment Plan] of Section 8.01(m)[Certificates of Borrowers; Other Reports and Information] is hereby amended by deleting the date "September 15, 1999" and inserting the date "September 30, 1999" in lieu thereof. (e) Subsection (o) [Cooperation with Agent] is hereby amended by adding the following after the first sentence of such subsection: "It is acknowledged and agreed that effective on the date hereof, the Agent and the Banks suspended the requirement that Ernst & Young LLP, independent financial advisor of the Agent and the Banks, review each Forecast Extension and each Forecast Reconciliation. It is expressly agreed that in the event that at any time on or after the Twenty-First Amendment Effective Date the Borrowers have an aggregate balance of cash on hand and in bank accounts of less than $15,000,000, the Borrowers shall provide prompt notice (the "Shortfall Notice") to the Agent and the Agent shall engage financial advisors, at the expense of the Borrowers, to review each Forecast Extension and each -2- 3 Forecast Reconciliation required to be delivered on or after the date of the Shortfall Notice." (f) Section 8.02(d) [Liquidations, Mergers, Consolidations, Acquisitions] is hereby amended and restated to read as follows: "(d) Liquidations, Mergers, Consolidations, Acquisitions. Each of the Loan Parties shall not, and shall not permit any of its Subsidiaries to, dissolve, liquidate or wind-up its affairs, or become a party to any merger or consolidation, or acquire by purchase, lease or otherwise all or substantially all of the assets or capital stock or other ownership interests of any other person, provided that (i) any wholly-owned Subsidiary of NovaCare may consolidate or merge into another Loan Party which is wholly-owned by one or more of the other Loan Parties, and (ii) any Loan Party may acquire all of the member interests in or certain assets of GP Therapy and all of the stock in or assets of Occupational Health Care Company, Inc. ("OHC")(each a "Permitted Acquisition"), provided that each of the following requirements is met; (A) the equity interests acquired by a Loan Party in G P Therapy and in OHC shall be pledged to the Agent for the benefit of the Banks on a first priority perfected basis in accordance with Section 11.18, a security interest in all assets acquired by a Loan Party of GP Therapy and OHC shall be granted to the Agent for the benefit of the Banks on a first priority perfected basis, G. P. Therapy and OHC shall join this Agreement as a Borrower or a Guarantor pursuant to Section 11.18 and shall have otherwise complied with Section 11.18 as a "Joining Subsidiary" as defined in Section 11.18, (B) the applicable board of directors or other equivalent governing body shall have approved such Permitted Acquisition, (C) no Potential Default or Event of Default shall exist immediately prior to and after giving effect to such Permitted Acquisition, (D) after giving effect to such Permitted Acquisition there shall be Available Revolving Credit Commitments of at least Five Million Dollars ($5,000,000), -3- 4 (E) the Consideration paid by the Loan Parties for the acquisition of all of the member interests or certain assets of in G. P. Therapy shall not exceed One Million Dollars ($1,000,000), and (F) the Consideration paid by the Loan Parties for the acquisition of all of the stock in or assets of OHC shall not exceed an aggregate of Five Million Dollars ($5,000,000), with the cash portion of such Consideration paid by the Loan Parties, directly or indirectly, not to exceed Two Million Dollars ($2,000,000)." 3. Other Matters. (a) Each Loan Party acknowledges that it has no claim, counterclaim, setoff, action or cause of action of any kind or nature whatsoever against all or any of the Agent, the Banks or any of the Agent's or the Banks' directors, officers, employees, agents, attorneys, legal representatives, successors and assigns (the Agent, the Banks and their directors, officers, employees, agents, attorneys, legal representatives, successors and assigns are collectively referred to as the "Lender Group"), that directly or indirectly arise out of or are based upon or in any manner connected with any "Prior Event" (as defined below), and each Loan Party hereby releases the Lender Group from any liability whatsoever should any nonetheless exist with respect to such claims. As used herein the term "Prior Event" means any transaction, event, circumstance, action, failure to act or occurrence of any sort or type, whether known or unknown, which occurred, existed, was taken, permitted or begun prior to the execution of this Twenty-First Amendment and occurred, existed, was taken, permitted or begun in accordance with, pursuant to or by virtue of any terms of this Twenty-First Amendment or any Loan Document or oral or written agreement relating to any of the foregoing. (b) Schedule 1.1 (E) [Excluded Entities], Schedule 6.01(c) [Subsidiaries] and Schedule 8.02(i)(v) [Restricted Investments in Excluded Entities] are amended and restated in their entirety to read as attached hereto. 4. Closing Fees and Certain Matters Regarding Financial Advisors. The Borrowers jointly and severally agree to reimburse the Agent on demand for all costs, expenses and disbursements relating to this Twenty-First Amendment which are payable by the Borrower as provided in Section 10.05 of the Credit Agreement. The Borrowers shall promptly deliver such certificates, resolutions and opinions in form and substance satisfactory to the Agent as the Agent shall have reasonably requested from time to time. The Borrowers jointly and severally agree to reimburse the Agent for the benefit of the Banks on demand for all reasonable fees and out-of-pocket expenses of Blank Rome Comisky & McCauley LLP, counsel to the Banks (or any substitute therefor), other local counsel engaged by the Banks, any financial advisors and other experts engaged by the Banks. -4- 5 5. Conditions of Effectiveness. The effectiveness of the waiver in Section 1 above and this Twenty-First Amendment is expressly conditioned upon the occurrence and completion of all of the following: (i) payment by the Borrowers of all costs, expenses and disbursements submitted on or before the date hereof to the Borrowers pursuant to Section 4 hereof, and (ii) the Agent's receipt of counterparts of this Twenty-First Amendment duly executed by the Borrowers, the Guarantors, the Agent and the Required Banks. This Twenty-First Amendment shall be dated as of and shall be effective as of the date and year first above written subject to satisfaction of all conditions precedent to effectiveness as set forth in this Section 5, which date shall be the Twenty-First Amendment Effective Date. 6. Consent of Banks. Pursuant to Section 11.01 of the Credit Agreement, this Twenty-First Amendment shall require the written consent of the Required Banks, which shall be evidenced by the execution and delivery by the Required Banks to the Agent of counterparts of this Twenty-First Amendment. 7. Full Force and Effect. Each of the following documents, as amended through and including this Twenty-First Amendment, shall remain in full force and effect on and after the date of this Amendment: (a) the Credit Agreement, except as expressly modified and amended by this Twenty-First Amendment, (b) each of the Schedules attached to the Credit Agreement, except as expressly modified and amended by this Twenty-First Amendment; (c) each of the Exhibits attached to the Credit Agreement; and the Notes, the Guaranty Agreements, the Security Agreement, the Pledge Agreements, the Agent's Fee Letter, the Subordination Agreement (Intercompany), the Borrower Agency Agreement and all other Loan Documents. On and after the date hereof, each reference in the Credit Agreement to "this Agreement," "hereunder" or words of like import shall mean and be a reference to the Credit Agreement, as previously amended and as amended by this Twenty-First Amendment, and each reference in each other Loan Document to the "Credit Agreement" shall mean and be a reference to the Credit Agreement, as previously amended and as amended by this Twenty-First Amendment. No novation is intended by this Twenty-First Amendment. -5- 6 The parties hereto do not amend or waive any provisions of the Credit Agreement or the other Loan Documents except as expressly set forth herein. 8. Counterparts. This Twenty-First Amendment may be executed by different parties hereto in any number of separate counterparts, each of which, when so executed and delivered, shall be an original, and all of such counterparts shall together constitute one and the same instrument. 9. Governing Law. This Twenty-First Amendment shall be deemed to be a contract under the laws of the Commonwealth of Pennsylvania and for all purposes shall be governed by and construed and enforced in accordance with the internal laws of the Commonwealth of Pennsylvania without regard to its conflict of laws principles. -6- 7 [Signature Page 1 of 19 to Twenty-First Amendment] IN WITNESS WHEREOF, the parties hereto, by their officers thereunto duly authorized, have executed this Amendment as of the day and year first above written. BORROWERS AND GUARANTORS: ATTEST: NOVACARE, INC., a Delaware corporation, and each of the BORROWERS and GUARANTORS listed on Schedule A attached hereto By: By: -------------------------------- ------------------------------------------ Richard S. Binstein, Secretary Richard A. McDonald, the Vice President of each Borrower and Guarantor listed on Schedule A attached hereto which is a corporation and of each general partner of each Guarantor listed on Schedule A attached hereto which is a partnership [Seal] ATTEST: NOVAFUNDS, INC., a Delaware corporation, and each of the GUARANTORS listed on Schedule B attached hereto By: By: -------------------------------- ------------------------------------------ Andrew T. Panaccione, Secretary Robert C. Campbell, the Vice President of each Borrower and Guarantor listed on Schedule B attached hereto [Seal] - --------------------
8 [Signature Page 2 of 19 to Twenty-First Amendment] AGENT: PNC BANK, NATIONAL ASSOCIATION, as Agent By: -------------------------------------- Title: ----------------------------------- BANKS: PNC BANK, NATIONAL ASSOCIATION By: -------------------------------------- Title: ----------------------------------- 9 [Signature Page 3 of 19 to Twenty-First Amendment] FIRST UNION NATIONAL BANK By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 10 [Signature Page 4 of 19 to Twenty-First Amendment] FLEET NATIONAL BANK By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 11 [Signature Page 5 of 19 to Twenty-First Amendment] MELLON BANK, N.A. By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 12 [Signature Page 6 of 19 to Twenty-First Amendment] NATIONSBANK, N.A. By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 13 [Signature Page 7 of 19 to Twenty-First Amendment] THE BANK OF NEW YORK By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 14 [Signature Page 8 of 19 to Twenty-First Amendment] SUNTRUST BANK, CENTRAL FLORIDA, N.A. By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 15 [Signature Page 9 of 19 to Twenty-First Amendment] BANK ONE, KENTUCKY, NA By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 16 [Signature Page 10 of 19 to Twenty-First Amendment] THE FUJI BANK, LIMITED NEW YORK BRANCH By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 17 [Signature Page 11 of 19 to Twenty-First Amendment] CRESTAR BANK By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 18 [Signature Page 12 of 19 to Twenty-First Amendment] BANK OF TOKYO - MITSUBISHI TRUST COMPANY By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 19 [Signature Page 13 of 19 to Twenty-First Amendment] AMSOUTH BANK By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 20 [Signature Page 14 of 19 to Twenty-First Amendment] BANK OF AMERICA, N.A. By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 21 [Signature Page 15 of 19 to Twenty-First Amendment] COMERICA BANK By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 22 [Signature Page 16 of 19 to Twenty-First Amendment] CREDIT LYONNAIS NEW YORK BRANCH By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 23 [Signature Page 17 of 19 to Twenty-First Amendment] COOPERATIEVE CENTRALE RAIFFEISEN- BOERENLEENBANK B.A., "RABOBANK NEDERLAND", NEW YORK BRANCH By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 24 [Signature Page 18 of 19 to Twenty-First Amendment] THE TOKAI BANK, LIMITED NEW YORK BRANCH By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 25 [Signature Page 19 of 19 to Twenty-First Amendment] TORONTO DOMINION (TEXAS), INC. By: ---------------------------------------- Name: ---------------------------------------- Title: ---------------------------------------- 26 STATE OF GEORGIA COUNTY OF FULTON On the _____ day of ___________, 1999 personally appeared ___________________, as the __________ President of SunTrust Bank, Central Florida, National Association, and before me executed the attached Twenty-First Amendment dated as of _____________, 1999 to the Credit Agreement between NovaCare, Inc., with SunTrust Bank, Central Florida, National Association, as Lender. IN WITNESS WHEREOF, I have hereunto set my hand and official seal, in the state and county aforesaid. _________________________________________________________ Signature of Notary Public, State of ____________________ _________________________________________________________ (Print, Type or Stamp Commissioned Name of Notary Public) Personally known _______________________; OR Produced Identification __________________________________________ Type of identification produced: ________________________ _________________________________________________________ 27 SCHEDULE A
BORROWER ("B") / ENTITY GUARANTOR ("G") - -------------------------------------------------------------------------------------- ---------------- NovaCare, Inc. (a Delaware corporation) B RehabClinics, Inc. B Rehab Managed Care of Arizona, Inc. B Affiliated Physical Therapists, Ltd. G American Rehabilitation Center, Inc. G American Rehabilitation Clinic, Inc. G Athens Sports Medicine Clinic, Inc. G Ather Sports Injury Clinic, Inc. G Atlantic Health Group, Inc. G Atlantic Rehabilitation Services, Inc. G Boca Rehab Agency, Inc. G Buendel Physical Therapy, Inc. G C.E.R. - West, Inc. G Cenla Physical Therapy & Rehabilitation Agency, Inc. G Center for Evaluation & Rehabilitation, Inc. G Center for Physical Therapy and Sports Rehabilitation, Inc. G CenterTherapy, Inc. G Central Missouri Rehabilitation Services, Inc. G Central Missouri Therapy, Inc. G Champion Physical Therapy, Inc. G CMC Center Corporation G Coplin Physical Therapy Associates, Inc. G Crowley Physical Therapy Clinic, Inc. G Douglas Avery and Associates, Ltd. G Douglas C. Claussen, R.P.T., Physical Therapy, Inc. G Elk County Physical Therapy, Inc. G Fine, Bryant & Wah, Inc. G Francis Naselli, Jr. & Stewart Rich Physical Therapists, Inc. G Gallery Physical Therapy Center, Inc. G
28
BORROWER ("B") / ENTITY GUARANTOR ("G") - -------------------------------------------------------------------------------------- ---------------- Georgia Health Group, Inc. G Georgia Physical Therapy of West Georgia, Inc. G Georgia Physical Therapy, Inc. G Greater Sacramento Physical Therapy Associates, Inc. G Grove City Physical Therapy and Sports Medicine, Inc. G Gulf Breeze Physical Therapy, Inc. G Gulf Coast Hand Specialists, Inc. G Hand Therapy and Rehabilitation Associates, Inc. G Hand Therapy Associates, Inc. G Hangtown Physical Therapy, Inc. G Hawley Physical Therapy, Inc. G Human Performance and Fitness, Inc. G Indianapolis Physical Therapy and Sports Medicine, Inc. G Industrial Health Care Company, Inc. G JOYNER SPORTS SCIENCE INSTITUTE, Inc. G JOYNER SPORTSMEDICINE INSTITUTE, INC. G Kentucky Rehabilitation Services, Inc. G Kesinger Physical Therapy, Inc. G Lynn M. Carlson, Inc. G Marilyn Hawker, Inc. G Mark Butler Physical Therapy Center, Inc. G Medical Plaza Physical Therapy, Inc. G Metro Rehabilitation Services, Inc. G Michigan Therapy Centre, Inc. G MidAtlantic Health Group, Inc. G Mill River Management, Inc. G Mitchell Tannenbaum I, Inc. G Mitchell Tannenbaum II, Inc. G Mitchell Tannenbaum III, Inc. G Monmouth Rehabilitation, Inc. G New England Health Group, Inc. G New Mexico Physical Therapists, Inc. G
29
BORROWER ("B") / ENTITY GUARANTOR ("G") - -------------------------------------------------------------------------------------- ---------------- Northside Physical Therapy, Inc. G NovaCare (Arizona), Inc. G NovaCare (Colorado), Inc. G NovaCare (Texas), Inc. G NovaCare Easton & Moran Physical Therapy, Inc. G NovaCare Holdings, Inc. G NovaCare Management Company, Inc. G NovaCare Management Services, Inc. G NovaCare Occupational Health Services, Inc. G NovaCare Outpatient Rehabilitation East, Inc. G NovaCare Outpatient Rehabilitation I, Inc. G NovaCare Outpatient Rehabilitation West, Inc. G NovaCare Outpatient Rehabilitation, Inc. G NovaCare Rehab Agency of Amarillo, Inc. G NovaCare Rehab Agency of Beaumont, Inc. G NovaCare Rehab Agency of El Paso, Inc. G NovaCare Rehab Agency of Las Vegas, Inc. G NovaCare Rehab Agency of Lubbock, Inc. G NovaCare Rehab Agency of Northern California, Inc. G NovaCare Rehab Agency of Oklahoma, Inc. G NovaCare Rehab Agency of Oregon, Inc. G NovaCare Rehab Agency of Reno, Inc. G NovaCare Rehab Agency of San Antonio, Inc. G NovaCare Rehab Agency of San Diego, Inc. G NovaCare Rehab Agency of Southern California, Inc. G NovaCare Rehab Agency of Washington, Inc. G NovaCare Rehab Agency of Wyoming, Inc. G NovaCare Rehabilitation, Inc. G NovaCare Service Corp. G Ortho Rehab Associates, Inc. G Orthopedic and Sports Physical Therapy of Cupertino, Inc. G
30
BORROWER ("B") / ENTITY GUARANTOR ("G") - -------------------------------------------------------------------------------------- ---------------- Peter Trailov R.P.T. Physical Therapy Clinic, Orthopaedic Rehabilitation & Sports G Medicine, Ltd. Peters, Starkey & Todrank Physical Therapy Corporation G Physical Focus Inc. G Physical Rehabilitation Partners, Inc. G Physical Therapy Clinic of Lee's Summit, Inc. G Physical Therapy Enterprises, Inc. G Physical Therapy Institute, Inc. G Physical Therapy Services of the Jersey Cape, Inc. G Pro Active Therapy, Inc. G Professional Therapeutic Services, Inc. G Quad City Management, Inc. G RCI (Colorado), Inc. G RCI (Exertec), Inc. G RCI (Illinois), Inc. G RCI (Michigan), Inc. G RCI (S.P.O.R.T.), Inc. G RCI (WRS), Inc. G RCI Nevada, Inc. G Rebound Oklahoma, Inc. G Redwood Pacific Therapies, Inc. G Rehab Provider Network of Florida, Inc. G Rehab Provider Network - California, Inc. G Rehab Provider Network - Delaware, Inc. G Rehab Provider Network - Georgia, Inc. G Rehab Provider Network - Illinois, Inc. G Rehab Provider Network - Indiana, Inc. G Rehab Provider Network - Maryland, Inc. G Rehab Provider Network - Michigan, Inc. G Rehab Provider Network - New Jersey, Inc. G Rehab Provider Network - Ohio, Inc. G Rehab Provider Network - Oklahoma, Inc. G Rehab Provider Network - Pennsylvania, Inc. G
31
BORROWER ("B") / ENTITY GUARANTOR ("G") - -------------------------------------------------------------------------------------- ---------------- Rehab Provider Network - Virginia, Inc. G Rehab Provider Network - Washington, D.C., Inc. G Rehab Provider Network of Colorado, Inc. G Rehab Provider Network of Nevada, Inc. G Rehab Provider Network of New Mexico, Inc. G Rehab Provider Network of North Carolina, Inc. G Rehab Provider Network of Texas, Inc. G Rehab Provider Network of Wisconsin, Inc. G Rehab World, Inc. G Rehab/Work Hardening Management Associates, Ltd. G RehabClinics (COAST), Inc. G RehabClinics (GALAXY), Inc. G RehabClinics (New Jersey), Inc. G RehabClinics (PTA), Inc. G RehabClinics (SPT), Inc. G RehabClinics Abilene, Inc. G RehabClinics Dallas, Inc. G RehabClinics Pennsylvania, Inc. G Rehabilitation Management, Inc. G Robert M. Bacci, R.P.T. Physical Therapy, Inc. G S.T.A.R.T., Inc. G Scott G. Knoche, Inc. G SG Rehabilitation Agency, Inc. G SG Speech Associates, Inc. G Sierra Nevada Physical Therapy Corporation G South Jersey Physical Therapy Associates, Inc. G South Jersey Rehabilitation and Sports Medicine Center, Inc. G Southpointe Fitness Center, Inc. G Southwest Emergency Associates, Inc. G Southwest Medical Supply Company G Southwest Physical Therapy, Inc. G Southwest Therapists, Inc. G
32
BORROWER ("B") / ENTITY GUARANTOR ("G") - -------------------------------------------------------------------------------------- ---------------- Sporthopedics Sports and Physical Therapy Centers, Inc. G Sports Therapy and Arthritis Rehabilitation, Inc. G Star Physical Therapy Inc. G Stephenson-Holtz, Inc. G The Center for Physical Therapy and Rehabilitation, Inc. G The Orthopedic Sports and Industrial Rehabilitation Network, Inc. G Theodore Dashnaw Physical Therapy, Inc. G Treister, Inc. G Union Square Center for Rehabilitation & Sports Medicine, Inc. G Valley Group Physical Therapists, Inc. G Vanguard Rehabilitation, Inc. G Wayzata Physical Therapy Center, Inc. G West Side Physical Therapy, Inc. G West Suburban Health Partners, Inc. G Western Missouri Rehabilitation Services, Inc. G Worker Rehabilitation Services, Inc. G Yuma Rehabilitation Center, Inc. G Advanced Orthopedic Services, Ltd. (RehabClinics Dallas, Inc. is general partner) G Land Park Physical Therapy (Union Square Center for Rehabilitation & Sports G Medicine, Inc. is general partner)
33 SCHEDULE B
BORROWER ("B") / ENTITY GUARANTOR ("G") - -------------------------------------------------------------------------------------- ---------------- NovaFunds, Inc. B NC Cash Management, Inc. G NC Resources, Inc. G NovaMark, Inc. G NovaStock, Inc. G
EX-21 4 SUBSIDIARIES OF THE COMPANY 1 Exhibit 21 SUBSIDIARIES OF THE COMPANY A.D. Craig Company, a California corporation Advance Orthotics, Inc., a Texas corporation Advanced Orthopedic Systems, Inc., a California corporation Advanced Orthopedic Technologies (Clayton), Inc., a New Jersey corporation Advanced Orthopedic Technologies (Lett), Inc., a West Virginia corporation Advanced Orthopedic Technologies (New Jersey), Inc., a New Jersey corporation Advanced Orthopedic Technologies (New Mexico), Inc., a New Mexico corporation Advanced Orthopedic Technologies (New York), Inc., a New York corporation Advanced Orthopedic Technologies (OTI), Inc., a New York corporation Advanced Orthopedic Technologies (Parmeco), Inc., a West Virginia corporation Advanced Orthopedic Technologies (SFV), Inc., a California corporation Advanced Orthopedic Technologies (Virginia), Inc., a Virginia corporation Advanced Orthopedic Technologies (West Virginia), Inc., a West Virginia corporation Advanced Orthopedic Technologies Management Corp., a New York corporation Advanced Orthopedic Technologies, Inc., a Nevada corporation Advanced Orthopedic Technologies, Inc., a New York corporation Advanced Orthotics and Prosthetics, Inc., a Washington corporation Affiliated Physical Therapists, Ltd., an Arizona corporation American Rehabilitation Center, Inc., a Missouri corporation American Rehabilitation Clinic, Inc., a Missouri corporation American Rehabilitation Systems, Inc., a Georgia corporation Artificial Limb and Brace Center, an Arizona corporation Athens Sports Medicine Clinic, Inc., a Georgia corporation Ather Sports Injury Clinic, Inc., a California corporation Atlanta Prosthetics, Inc., a Georgia corporation Atlantic Health Group, Inc., a Delaware corporation Atlantic Rehabilitation Services, Inc., a New Jersey corporation Boca Rehab Agency, Inc., a Delaware corporation Bowman-Shelton Orthopedic Service, Incorporated, an Oklahoma corporation Buendel Physical Therapy, Inc., a Florida corporation C.E.R. - West, Inc., a Michigan corporation CCISUB, Inc., a North Carolina corporation CMC Center Corporation, a California corporation Cahill Orthopedic Laboratory, Inc., a New York corporation Cenla Physical Therapy & Rehabilitation Agency, Inc., a Louisiana corporation Center for Evaluation & Rehabilitation, Inc., a Michigan corporation Center for Physical Therapy & Sports Rehabilitation, Inc., a New Mexico corporation CenterTherapy, Inc., a Minnesota corporation Central Missouri Rehabilitation Services, Inc., a Missouri corporation Central Missouri Therapy, Inc., a Missouri corporation Central Valley Prosthetics & Orthotics, Inc., a California corporation Certified Orthopedic Appliance Co., Inc., an Arizona corporation Champion Physical Therapy, Inc., a Pennsylvania corporation Coplin Physical Therapy Associates, Inc., a Minnesota corporation Crowley Physical Therapy Clinic, Inc., a Louisiana corporation Dale Clark Prosthetics, Inc., an Iowa corporation Douglas Avery & Associates, Ltd., a Virginia corporation 2 Douglas C. Claussen, R.P.T., Physical Therapy, Inc., a California corporation E.A. Warnick-Pomeroy Co., Inc., a Pennsylvania corporation Elk County Physical Therapy, Inc., a Pennsylvania corporation Employee Benefits Management, Inc., a Florida corporation Employers' Risk Management, Inc., a Florida corporation Fine, Bryant & Wah, Inc., a Maryland corporation Francis Naselli, Jr. & Stewart Rich Physical Therapists, Inc., a Pennsylvania corporation Frank J. Malone & Son, Inc., a Pennsylvania corporation Fresno Orthopedic Company, a California corporation G.P. Therapy, L.L.C., a Georgia limited liability company Gallery Physical Therapy Center, Inc., a Minnesota corporation Georgia Health Group, Inc., a Georgia corporation Georgia Physical Therapy of West Georgia, Inc., a Georgia corporation Georgia Physical Therapy, Inc., a Georgia corporation Gill/Balsano Consulting, L.L.C., a Delaware limited liability corporation Greater Sacramento Physical Therapy Associates, Inc., a California corporation Grove City Physical Therapy and Sports Medicine, Inc., a Pennsylvania corporation Gulf Breeze Physical Therapy, Inc., a Florida corporation Gulf Coast Hand Specialists, Inc., a Florida corporation Hand Therapy and Rehabilitation Associates, Inc., a California corporation Hand Therapy Associates, Inc., an Arizona corporation Hangtown Physical Therapy, Inc., a California corporation Hawley Physical Therapy, Inc., a California corporation High Desert Institute of Prosthetics and Orthotics, a California corporation Human Performance and Fitness, Inc., a California corporation Indianapolis Physical Therapy and Sports Medicine, Inc., an Indiana corporation Industrial Health Care Company, Inc., a Connecticut corporation J.E. Hanger, Incorporated, a Missouri corporation JOYNER SPORTS SCIENCE INSTITUTE, Inc., a Pennsylvania corporation JOYNER SPORTSMEDICINE INSTITUTE, INC., a Pennsylvania corporation Joyner/Wendt-Bristol, L.L.C. Kentucky Rehabilitation Services, Inc., a Kentucky corporation Kesinger Physical Therapy, Inc., a California corporation Kroll's, Inc., a Minnesota corporation Lynn M. Carlson, Inc., an Arizona corporation Marilyn Hawker, Inc., an Arizona corporation Mark Butler Physical Therapy Center, Inc., a New Jersey corporation McKinney Prosthetics/Orthotics, Inc., an Illinois corporation Meadowbrook Orthopedics, Inc., a Michigan corporation Medical Arts O&P Services, Inc., a Wisconsin corporation Medical Plaza Physical Therapy, Inc., a Missouri corporation Metro Rehabilitation Services, Inc., a Michigan corporation Michigan Therapy Centre, Inc., a Michigan corporation MidAtlantic Health Group, Inc., a Delaware corporation Mitchell Tannenbaum I, Inc., an Illinois corporation Mitchell Tannenbaum II, Inc., an Illinois corporation Mitchell Tannenbaum III, Inc., an Illinois corporation Monmouth Rehabilitation, Inc., a New Jersey corporation NC Cash Management, Inc., a Delaware corporation NC Resources, Inc., a Delaware corporation NCES Finance, Inc., a Delaware corporation 3 NCES Holdings, Inc., a Delaware corporation NCES Licensing , Inc., a Delaware corporation New England Health Group, Inc., a Massachusetts corporation New Mexico Physical Therapists, Inc., a New Mexico corporation Northland Regional Orthotic and Prosthetic Center, Inc., a Minnesota corporation Northside Physical Therapy, Inc., an Ohio corporation NovaCare (Arizona), Inc., an Arizona corporation NovaCare (Colorado), Inc., a Delaware corporation NovaCare (Texas), Inc., a Texas corporation NovaCare Administrative Employee Services of New York, Inc., a New York corporation NovaCare Administrative Employee Services, Inc., a Florida corporation NovaCare Easton & Moran Physical Therapy, Inc., a California corporation NovaCare Employee Services Club Staff, Inc., a Florida corporation NovaCare Employee Services Easy Staff, Inc., a Florida corporation NovaCare Employee Services Northeast, Inc., a New York corporation NovaCare Employee Services Resource One, Inc., a Florida corporation NovaCare Employee Services TPI, Inc., a New York corporation NovaCare Employee Services West, Inc., an Arizona corporation NovaCare Employee Services of America, Inc., a Florida corporation NovaCare Employee Services of Boston, Inc., a Delaware corporation NovaCare Employee Services of Florida, Inc., a Florida corporation NovaCare Employee Services of New York, Inc., a New York corporation NovaCare Employee Services of Orlando, Inc., a Florida corporation NovaCare Employee Services, Inc., a Delaware corporation NovaCare Management Company, Inc., a Delaware corporation NovaCare Management Services, Inc., a Delaware corporation NovaCare Occupational Health Services, Inc., a Delaware corporation NovaCare Orthotics & Prosthetics, Inc., a Delaware corporation NovaCare Orthotics & Prosthetics East, Inc., a Delaware corporation NovaCare Orthotics & Prosthetics Holdings, Inc., a Delaware corporation NovaCare Orthotics & Prosthetics West, Inc., a California corporation NovaCare Outpatient Rehabilitation East, Inc., a Delaware corporation NovaCare Outpatient Rehabilitation I, Inc., a Kansas corporation NovaCare Outpatient Rehabilitation, Inc., a Kansas corporation NovaCare Outpatient Rehabilitation West, Inc., a Delaware corporation NovaCare Rehab Agency of Amarillo, Inc., a Texas corporation NovaCare Rehab Agency of Beaumont, Inc., a Texas corporation NovaCare Rehab Agency of El Paso, Inc., a Texas corporation NovaCare Rehab Agency of Las Vegas, Inc., a Nevada corporation NovaCare Rehab Agency of Lubbock, Inc., a Texas corporation NovaCare Rehab Agency of Northern California, Inc., a California corporation NovaCare Rehab Agency of Oklahoma, Inc., an Oklahoma corporation NovaCare Rehab Agency of Oregon, Inc., an Oregon corporation NovaCare Rehab Agency of Reno, Inc., a Nevada corporation NovaCare Rehab Agency of San Antonio, Inc., a Texas corporation NovaCare Rehab Agency of San Diego, Inc., a California corporation NovaCare Rehab Agency of Southern California, Inc., a California corporation NovaCare Rehab Agency of Washington, Inc., a Washington corporation NovaCare Rehab Agency of Wyoming, Inc., a Wyoming corporation NovaCare Rehabilitation, Inc., a Minnesota corporation 4 NovaCare Service Corp., a Delaware corporation NovaCare, Inc., a Delaware corporation NovaFunds, Inc., a Delaware corporation NovaMark, Inc., a Delaware corporation NovaStock, Inc., a Delaware corporation Opus Care, Inc., an Illinois corporation Ortho East, Inc., a Massachusetts corporation Ortho-Fab Laboratories, Inc., an Illinois corporation Ortho Rehab Associates, Inc., a Florida corporation Orthopedic and Sports Physical Therapy of Cupertino, Inc., a California corporation Orthopedic Appliances, Inc., an Iowa corporation Orthopedic Rehabilitative Services, Ltd., an Illinois corporation Orthotic & Prosthetic Rehabilitation Technologies, Inc., a Florida corporation Orthotic and Prosthetic Associates, Inc., a Massachusetts corporation Orthotic Specialists, Inc., a Michigan corporation Paralign Staffing Technologies, Inc., an Arizona corporation Peter Trailov R.P.T. Physical Therapy Clinic, Orthopaedic Rehabilitation & Sports Medicine, Ltd., an Illinois corporation Peters, Starkey & Todrank Physical Therapy Corporation, a California corporation Physical Focus, Inc., a Delaware corporation Physical Rehabilitation Partners, Inc., a Louisiana corporation Physical Restoration Laboratories, Inc. an Illinois corporation Physical Therapy Clinic of Lee's Summit, Inc., a Missouri corporation Physical Therapy Enterprises, Inc., an Arizona corporation Physical Therapy Institute, Inc., a Louisiana corporation Physical Therapy Services of the Jersey Cape, Inc., a New Jersey corporation Pro Active Therapy of Ahoskie, Inc., a North Carolina corporation Pro Active Therapy of Gaffney, Inc., a South Carolina corporation Pro Active Therapy of Greenville, Inc., a North Carolina corporation Pro Active Therapy of North Carolina, Inc., a North Carolina corporation Pro Active Therapy of Rocky Mount, Inc., a North Carolina corporation Pro Active Therapy of South Carolina, Inc., a South Carolina corporation Pro Active Therapy of Virginia, Inc., a Virginia corporation Pro Active Therapy, Inc., a North Carolina corporation Professional Insurance Planners of Florida, Inc., a Florida corporation Professional Orthotics and Prosthetics, Inc., a New Mexico corporation Professional Orthotics and Prosthetics, Inc. of Santa Fe, a New Mexico corporation Professional Therapeutic Services, Inc., an Ohio corporation Progressive Orthopedic , a California corporation Prosthetics-Orthotics Associates, Inc. an Illinois corporation Protech Orthotic and Prosthetic Center, Inc., an Illinois corporation Quad City Management, Inc., an Iowa corporation RCI (Colorado), Inc., a Delaware corporation RCI (Exertec), Inc., a Delaware corporation RCI (Illinois), Inc., an Illinois corporation RCI (Michigan), Inc., a Delaware corporation RCI (S.P.O.R.T.), Inc., a Delaware corporation RCI (WRS), Inc., an Illinois corporation RCI Nevada, Inc., a Delaware corporation Rebound Oklahoma, Inc., an Oklahoma corporation Redwood Pacific Therapies, Inc., a California corporation 5 Rehab Managed Care of Arizona, Inc., a Delaware corporation Rehab Provider Network - California, Inc., a California corporation Rehab Provider Network - Delaware, Inc., a Delaware corporation Rehab Provider Network - Georgia, Inc., a Georgia corporation Rehab Provider Network - Illinois, Inc., an Illinois corporation Rehab Provider Network - Indiana, Inc., an Indiana corporation Rehab Provider Network - Maryland, Inc., a Maryland corporation Rehab Provider Network - Michigan, Inc., a Michigan corporation Rehab Provider Network - New Jersey, Inc., a New Jersey corporation Rehab Provider Network - Ohio, Inc., an Ohio corporation Rehab Provider Network - Oklahoma, Inc., an Oklahoma corporation Rehab Provider Network - Pennsylvania, Inc., a Pennsylvania corporation Rehab Provider Network - Virginia, Inc., a Virginia corporation Rehab Provider Network - Washington, D.C., Inc., a District of Columbia corporation Rehab Provider Network of Colorado, Inc., a Colorado corporation Rehab Provider Network of Florida, Inc., a Florida corporation Rehab Provider Network of Nevada, Inc., a Nevada corporation Rehab Provider Network of New Mexico, Inc., a New Mexico corporation Rehab Provider Network of North Carolina, Inc., a North Carolina corporation Rehab Provider Network of Texas, Inc., a Texas corporation Rehab Provider Network of Wisconsin, Inc., a Wisconsin corporation Rehab World, Inc., a Delaware corporation Rehab/Work Hardening Management Associates, Ltd., a Pennsylvania corporation RehabClinics (COAST), Inc., a Delaware corporation RehabClinics (GALAXY), Inc., an Illinois corporation RehabClinics (New Jersey), Inc., a Delaware corporation RehabClinics (PTA), Inc., a Delaware corporation RehabClinics (SPT), Inc., a Delaware corporation RehabClinics Abilene, Inc., a Delaware corporation RehabClinics Dallas, Inc., a Delaware corporation RehabClinics Pennsylvania, Inc., a Pennsylvania corporation RehabClinics, Inc., a Delaware corporation Rehabilitation Fabrication, Inc., a Massachusetts corporation Rehabilitation Management, Inc., a Delaware corporation Reid Medical System, Inc., a Florida corporation Robert M. Bacci, R.P.T. Physical Therapy, Inc., a California corporation Robin-Aids Prosthetics, Inc., a California corporation S.T.A.R.T., Inc., a Massachusetts corporation SG Rehabilitation Agency, Inc, a Pennsylvania corporation SG Speech Associates, Inc., a Pennsylvania corporation Salem Orthopedic & Prosthetic, Inc., an Oregon corporation San Joaquin Orthopedic, Inc., a California corporation Scott G. Knoche, Inc., a Missouri corporation Sierra Nevada Physical Therapy Corporation, a California corporation South Jersey Physical Therapy Associates, Inc., a New Jersey corporation South Jersey Rehabilitation and Sports Medicine Center, Inc., a New Jersey corporation Southern Illinois Prosthetic & Orthotic, Ltd., an Illinois corporation Southern Illinois Prosthetic & Orthotic of Missouri, Ltd., a Missouri corporation Southpointe Fitness Center, Inc., a Pennsylvania corporation Southwest Emergency Associates, Inc., an Arizona corporation Southwest Medical Supply Company, a New Mexico corporation 6 Southwest Physical Therapy, Inc., a New Mexico corporation Southwest Therapists, Inc., a New Mexico corporation Sporthopedics Sports and Physical Therapy Centers, Inc., a California corporation Sports Therapy and Arthritis Rehabilitation, Inc., a Delaware corporation Star Physical Therapy, Inc., a Florida corporation Stephenson-Holtz, Inc., a California corporation T.D. Rehab Systems, Inc., a New Jersey corporation T.J. Corporation I, L.L.C., a Delaware limited liability corporation T.J. Partnership I, a Delaware general partnership Texoma Health Care Center, Inc., a Texas corporation The Center for Physical Therapy and Rehabilitation, Inc., a New Mexico corporation The Orthopedic Sports and Industrial Rehabilitation Network, Inc., a Pennsylvania corporation Theodore Dashnaw Physical Therapy, Inc., a California corporation Treister, Inc., an Ohio corporation Tucson Limb & Brace, Inc., an Arizona corporation Union Square Center for Rehabilitation & Sports Medicine, Inc., a California corporation University Orthotic & Prosthetic Consultants, Ltd., a Pennsylvania corporation Valley Group Physical Therapists, Inc., a Pennsylvania corporation Vanguard Rehabilitation, Inc., an Arizona corporation Wayzata Physical Therapy Center, Inc., a Minnesota corporation West Side Physical Therapy, Inc., an Ohio corporation West Suburban Health Partners, Inc., a Minnesota corporation Western Missouri Rehabilitation Services, Inc., a Missouri corporation Worker Rehabilitation Services, Inc., an Illinois corporation Yuma Rehabilitation Center, Inc., an Arizona corporation EX-23 5 CONSENT OF INDEPENDENT ACCOUNTANTS 1 Exhibit 23 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 33-88744, 33-88745, 33-88746 and 333-70653) of NovaCare, Inc. of our report dated August 30, 1999, except for third and fourth paragraphs of Note 2 as to which the date is September 10, 1999, which report includes an explanatory paragraph addressing matters which raise substantial doubt about the Company's ability to continue as a growing concern, relating to the financial statements and financial statement schedule, which appears on page 59 of this Form 10-K. PricewaterhouseCoopers LLP Philadelphia, PA September 20, 1999 EX-27 6 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED BALANCE SHEET AS OF JUNE 30, 1999 AND THE CONSOLIDATED STATEMENT OF OPERATIONS FOR THE YEAR ENDED JUNE 30, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH STATEMENT IN FORM 10-K FOR THE YEAR ENDED JUNE 30, 1999. 0000802843 NOVACARE,INC. 1,000 US DOLLAR YEAR JUN-30-1999 JUN-30-1998 JUN-30-1999 1 23,277 0 231,866 38,459 44,651 388,490 122,655 (62,911) 1,204,865 684,822 54,237 0 0 686 392,573 1,204,865 0 1,477,917 0 1,430,210 68,540 42,540 41,592 (104,965) (23,129) (81,836) (107,775) 0 0 (189,611) (3.02) (3.02) "TOTAL COSTS" CONSIST OF COST OF SERVICES AND SELLING AND ADMINISTRATIVE EXPENSES. "OTHER EXPENSES" CONSIST OF AMORTIZATION OF GOODWILL, MINORITY INTEREST, PROVISION FOR RESTRUCTURE AND INVESTMENT LOSS, NET, OFFSET BY GAIN FROM ISSUANCE OF SUBSIDIARY STOCK. "EPS" IS CALCULATED USING NET INCOME. EPS FROM CONTINUING OPERATIONS ONLY IS $(1.30).
-----END PRIVACY-ENHANCED MESSAGE-----