========================================================================= SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 _______ FORM 10-K Annual Report Pursuant to Section 13 or 15(d) of The Securities Exchange Act of 1934 For the fiscal year ended Commission File No. December 31, 1998 333-37185 _______ NATIONAL HEALTHCARE CORPORATION (Exact name of registrant as specified in its Corporate Charter) Delaware 52-2057472 (State of Formation) (I.R.S. Employer I.D. No.) 100 Vine Street Murfreesboro, Tennessee 37130 (Address of principal executive offices) Telephone Number: 615-890-2020 Securities registered pursuant to Section 12(b) of the Act. Name of Each Exchange on Title of Each Class which Registered _________________________________________________________________________ Shares of Common Stock American Stock Exchange Senior Subordinated Convertible Debentures Due 2000 (6%) American Stock Exchange Securities registered pursuant to Section 12(g) of the Act: Same Indicate by check mark whether the registrant (a) 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] The aggregate market of voting shares held by nonaffiliates of the registrant was $75,353,000 as of February 26, 1999. Number of Shares outstanding as of February 26, 1999: 11,383,004 Page 1 of 85 Pages Exhibit Index Page 55 =====================================================================
PART 1 ------ ITEM 1 BUSINESS General National HealthCare Corporation (NHC or the Company) is the successor by merger to National HealthCare L.P. effective 11:59 p.m., December 31, 1997. NHC is a corporation organized under the laws of the State of Delaware. It principally operates long-term health care centers and home health care programs in the southeastern United States. The Company's health care centers provide subacute, skilled and intermediate nursing and rehabilitative care. At December 31, 1998, the Company operated 108 long-term health care centers with a total of 13,983 licensed beds. Of the 108 centers operated, 40 are leased from National Health Investors, Inc. (NHI), 18 are leased from National Health Realty, Inc. (NHR) and 50 are managed for other owners. The Company serves as a compensated Investment Advisor to both NHI and NHR. The Company's homecare programs provide rehabilitative care at a patient's residence. During 1998, the Company operated 35 homecare programs and provided 328,638 homecare patient visits. NHC also operates 445 retirement apartments located in four retirement centers leased from NHI, one retirement center leased from NHR and one managed retirement center. Additionally, the Company operates 774 assisted living units at 14 leased centers (eight from NHI and six from NHR)and two managed centers. During 1998, NHC opened 289 new health care beds, 142 in owned/leased centers and 147 in managed centers. During the year, construction started on three new centers with 345 beds, expansion of six leased centers (81 beds), and a total of 35 managed beds in two locations. A total of 461 beds were under construction at year end. Finally, NHC has obtained certificates of need for the construction of 858 beds at eight owned, leased or managed locations, all of which are expected to start construction in 1999. As of December 31, 1998, the Company operated specialized care units such as Alzheimer's Disease care units (21), sub-acute nursing units (17) and a number of in house pharmacies. Similar specialty units are under development or consideration at a number of the Company's centers, as well as free standing projects. Additional Services. The Company plans to continue to expand its continuum of care for the elderly by offering a comprehensive and increasing range of services through related or separately structured health care centers, homecare programs, specialized care units, pharmacy operations, rehabilitative services, assisted living centers and retirement centers. Highlights of these activities during 1998 were as follows: A. Homecare Programs. The Company's policy has been to affiliate each of its licensed and certified homecare programs with a Company operated health care center. Although the existing programs have decreased their total number of visits from 731,349 in 1997 to 328,638 in 1998, this is a result of the changes in Medicare reimbursement under the Balanced Budget Act of 1997. This new reimbursement program for homecare services under the Medicare program pays for a fixed amount for each recipient irrespective of the number of visits, thus the Company is now focusing on its homecare patient census rather than number of visits. Programs that are not profitable due to census
constraints are being closely evaluated and the Company plans to discontinue such non productive programs in 1999. B. Rehabilitative Services. The Company has long operated an intensive offering of physical, speech, and occupational therapy provided by center specific therapists. NHC maintained a rehabilitation staff of over 1,000 highly trained, professional therapists in 1998, most of which were employed by a separate rehabilitation subsidiary known as NHC Rehabilitation. In addition to serving NHC operated centers, it provides contract services to 560 health care providers owned by third parties. The Company's rates for these services are competitive with other market rates. Major Medicare reimbursement changes occurred for therapy services in 1998 and will continue to occur during 1999. In 1998 reimbursement was limited to published "salary equivalents" and licensed skilled nursing centers must bill Medicare directly. In 1999 skilled nursing centers Medicare per diems will become prospective and will include no separate payment for therapy services. This system will be phased in over a four year period. The Company has terminated substantially all of its therapists, but has offered to rehire those who so desire as center based employees. A substantial number has so elected. Because of these changes, the Company anticipates a substantial decrease in third party contracts in 1999, but also a substantial decrease in center based expenses. C. Medical Specialty Units. The Company has required all of its centers to participate in the Medicare program since 1973, and has continually expanded its range of offerings by the creation of center-specific medical specialty units such as the Company's 21 Alzheimer's disease care units and 17 subacute nursing units. The services are provided not only at each NHC operated center, but also at existing specialized care units. D. Pharmacy Operations. The Company's policy has been to have an in-house pharmacy located in each health care center in those states where licensure permits the operation of an in-house pharmacy. In other states, pharmaceutical services have been provided by third party contracts. NHC continues to review opportunities for regional pharmacy operations and now operates four (one in east Tennessee, one in South Carolina, and two in central Florida). These pharmacy operations operate out of a central office and supply (on a separate contractual basis) pharmaceutical services and supplies which were formerly purchased by each center from local vendors. The regional pharmacy operations now have 8,119 skilled nursing home beds under contract. Pharmacy reimbursement under Medicare has also been shifted from direct billing by the pharmacy, to a negotiated rate structure between skilled nursing centers and the pharmacy, with the skilled nursing centers Medicare reimbursement being based upon a prospective rate not related to actual patient pharmaceutical usage. The Company anticipates decreased revenues for its pharmacy subsidiary as a result. E. Assisted Living Projects. The Company presently owns, leases or manages sixteen assisted living projects, nine of which are located within the physical structure of a long-term health care
center or retirement complex. The Company has identified the assisted living market as an expanding area for the delivery of health care and hospitality services and has a planned market review process in its states of operation for the construction of free-standing assisted living centers. One 84 unit free standing assisted living project opened in 1998, and construction is anticipated to start on three projects during 1999, each of which will be associated with an NHC operated health care center. Assisted living units provide basic room and board functions for the elderly with the on-staff availability to assist in minor medical needs on an as needed basis. F. Managed Care Contracts. The Company operates seven regional contract management offices, staffed by experienced case managers who contract with managed care organizations (MCO's) and insurance carriers for the provision of subacute and other medical specialty services within a regional cluster of centers. Managed care days have increased from 50,113 in 1996 and 71,606 in 1997 to 81,099 in 1998. In fiscal year 1998, 91.6% of the Company's net revenues were derived from health care services and 8.4% from other sources. Long-Term Health Care Centers The health care centers operated by the Company provide in-patient skilled and intermediate nursing care services and in-patient and out-patient rehabilitation services. Skilled nursing care consists of 24-hour nursing service by registered or licensed practical nurses and related medical services prescribed by the patient's physician. Intermediate nursing care consists of similar services on a less intensive basis principally provided by non-licensed personnel. These distinctions are generally found in the long-term health care industry although for Medicaid reimbursement purposes, some states in which the Company operates have additional classifications, while in other states the Medicaid rate is the same regardless of patient classification. Rehabilitative services consist of physical, speech, and occupational therapies, which are designed to aid the patient's recovery and enable the patient to resume normal activities. Each health care center has a licensed administrator responsible for supervising daily activities, and larger centers have assistant administrators. All have medical directors, a director of nurses and full-time registered nurse coverage. All centers provide physical therapy and most have other rehabilitative programs, such as occupational or speech therapy. Each facility is located near at least one hospital and is qualified to accept patients discharged from such hospitals. Each center has a full dining room, kitchen, treatment and examining room, emergency lighting system, and sprinkler system where required. Management believes that all centers are in compliance with the existing fire and life safety codes. The Company has developed a quality certification program which it utilizes in each of its health care centers to verify that high standards of care are maintained. An integral part of the program is a computerized patient assessment system which aids in placing the patient in the appropriate section of each center (skilled or intermediate) and monitors the health care
needs of the patient, number and frequency of medications and other essential medical information. The data derived from this system is used not only to assure that appropriate care is given to each individual patient, but also to ascertain the appropriate amount of staffing of each section of the center. Additionally, the Company requires a patient care survey to be performed at least quarterly by the regional and home office nursing support team, and a "consumer view" survey by senior management at least twice a year. The Company developed and promotes a "customer satisfaction" rating system, using 1993 as a bench mark, and requires significant improvement in the ratings by each center as a condition of participation in the Company's overall "Excellence Program". The Company provides centralized management and support services to the Company's health care nursing centers. The management and support services include operational support through the use of regional vice presidents and regional nurses, accounting and financial services, cash management, data processing, legal, consulting and services in the area of rehabilitative care. All personnel are employed by the Company's administrative services affiliate, National Health Corporation, which is also responsible for overall services in the area of personnel, loss control, insurance, education and training. The Company reimburses the administrative services contractor by paying all the costs of personnel employed for the benefit of the Company as well as a fee. National Health Corporation (National) is wholly owned by the National Health Corporation Employee Stock Ownership Plan and provides its services only to the Company. National was the Administrative General Partner during the eleven years the Company's organizational form was as a publicly traded partnership. The Company provides identical management services to centers operated under management contracts as it provides to centers owned or leased by the Company. The term of each contract and the amount of the management fee are determined on a case-by-case basis. Typically, the Company charges 6% of net revenues. The initial term of the contracts range from five years to twenty years. The Company maintains a right of first refusal should any owner desire to sell a managed center and, in certain situations, special termination payments have been negotiated should an owner sell to a third party or terminate or non-renew a management contract. All health care centers operated by the Company are licensed by the appropriate state and local agencies. All except two are certified as providers for Medicaid patients, and all are certified as Medicare providers. All of the Company's centers are subject to state and federal licensure and certification surveys. These surveys, from time to time, may produce statements of deficiencies. In response to such a statement, if any, the staff at each center would file a plan of correction after consultation with the Regional Vice President and any alleged deficiencies would be corrected. Presently, none of the Company's facilities are operating under material statements of deficiencies. The Company has a significant monetary bonus to employees attached to passing these surveys with few or no deficiencies. Health Care Centers Under Construction The following table sets forth the long-term health care centers or additions to existing centers currently under construction which the Company owns, leases or manages:
<TABLE> <CAPTION> Number Owned/Leased/ Projected Location of Beds Managed Opening Date -------- ------- ------------- ------------ <S> <C> <C> <C> Stuart, FL 35* Leased March 1999 Murfreesboro, TN 20* Leased March 1999 Plant City, FL 8* Leased April 1999 Madison, FL 20* Managed March 1999 -- Total 83 *Expansion of existing center </TABLE> Construction Starts in 1999 The following table sets forth the new beds authorized by governmental certificates of need which are anticipated to start construction in 1999. <TABLE> <CAPTION> Number Number of Number of of Beds New Centers Existing Centers ------- ----------- ---------------- <S> <C> <C> <C> Owned 648 6 0 Leased 0 0 0 Managed 210 0 2 --- - - Total 858 6 2 </TABLE> Occupancy Rates The following table shows certain information relating to occupancy rates for the Company's continuing owned and leased long-term health care centers: <TABLE> <CAPTION> Year Ended December 31 1998 1997 1996 ---- ---- ---- <S> <C> <C> <C> Overall census 90.8% 92.2% 93.0% Census excluding acquisitions and new openings 92.9% 94.6% 93.0% </TABLE> Occupancy rates are calculated by dividing the total number of days of patient care provided by the number of patient days available (which is determined by multiplying the number of licensed beds by 365 or 366). Homecare Programs The Company's home health programs (called "Homecare" by the Company) provide nursing and rehabilitative services to individuals in their residences and are licensed by the Tennessee, South Carolina and Florida state governments and certified by the federal government for participation in the Medicare program. Each of the Company's 35 Medicare certified homecare programs is managed by a registered nurse, with speech, occupational and physical therapists either employed by the program or on a contract basis. Homecare visits decreased from 731,000 visits in 1997 to 328,638 visits in 1998. The new reimbursement program for homecare services under the Medicare program will pay for a fixed amount for each recipient irrespective of the number of visits. Thus, the Company is now focusing on its homecare patient
census rather than number of visits. Programs that are not profitable due to census constraints are being closely evaluated and the Company plans to discontinue such non productive programs in 1999. The Company has homecare programs in Tennessee, Florida, and South Carolina. The Company's Tennessee homecare programs are associated with its long-term health care centers and, historically, are based within the health care center. The Company's newer homecare programs are separately based in an effort to continually expand NHC's market leadership in these services. The Company's experience in this field indicates that homecare is not a substitute for institutional care in a hospital or health care center. Instead, the Company's homecare programs provide an additional level of health care because its centers can provide services to patients after they have been discharged from the center or prior to their admission. Assisted Living Units The Company presently leases and manages sixteen assisted living units, nine of which are located within the physical structure of a long-term health care center or retirement center and seven of which are freestanding. The Company opened one assisted living unit during 1998. This opening increased NHC's assisted living units from 729 in 1997 to 774 in 1998. The Company plans to start construction on at least three free standing assisted living projects each year with the first priority being to serve markets in which the Company already operates health care centers. Assisted living units provide basic room and board functions for the elderly with the on-staff availability to assist in minor medical needs on an as needed basis. Certificates of Need are not necessary to build these projects and the Company believes that overbuilding has occurred in some of its markets. The Company expects to start construction on three free standing projects in 1999, all of which will be adjacent to NHC operated skilled nursing beds. Retirement Centers NHC's retirement centers offer specially designed residential units for the active and ambulatory elderly and provide various ancillary services for their residents, including restaurants, activity rooms and social areas. In most cases, retirement centers also include long-term health care facilities, either in contiguous or adjacent licensed health care centers. Charges for services are paid from private sources without assistance from governmental programs. Retirement centers may be licensed and regulated in some states, but do not require the issuance of a Certificate of Need such as is required for health care centers. NHC has, in most cases, developed retirement centers adjacent to its health care properties with an initial construction of 15 to 40 units and which units are rented by the month; thus these centers offer an expansion of the Company's continuum of care. The projects are designed, however, to be expandable if the demand justifies. The Company believes these retirement units offer a positive marketing aspect of the Company's health care centers. Another type of retirement center which the Company offers is that of "continuing care communities", where the resident pays a substantial endowment fee and a monthly maintenance fee. The resident then receives a full range of services - including nursing home care - without additional charge.
One such continuing care community, the 137 unit Richland Place Retirement Center, was opened in January, 1993 and is fully occupied. The Company opened the 58 unit AdamsPlace in Murfreesboro, Tennessee during 1998 and is marketing a proposed independent living center in Farragut, Tennessee. The Company has land under contract for similar communities in Franklin, Tennessee, and Charleston, South Carolina. Sources of Revenue The Company's revenues are primarily derived from its health care centers. The source and amount of the revenues are determined by (i) the licensed bed capacity of its health care centers, (ii) the occupancy rate of those centers, (iii) the extent to which the rehabilitative and other skilled ancillary services provided at each center are utilized by the patients in the centers, (iv) the mix of private pay, Medicare and Medicaid patients, and (v) the rates paid by private paying patients and by the Medicare and Medicaid programs. The following table sets forth sources of patient revenues from health care centers and homecare services for the periods indicated: <TABLE> <CAPTION> Year Ended Dec 31 Source 1998 1997 1996 ------ ---- ---- ---- <S> <C> <C> <C> Private 31% 28% 28% Medicare 32% 38% 38% Medicaid/Skilled 10% 9% 9% Medicaid/Intermediate 26% 24% 24% VA and Other 1% 1% 1% --- --- --- Total 100% 100% 100% </TABLE> Government Health Care Reimbursement Programs The federal health insurance program for the aged is Medicare, which is administered by the Department of Health and Human Services. State programs for medical assistance to the indigent are known as Medicaid in states which the Company operates. All health care centers operated by the Company are certified to participate in Medicare and all but two participate in Medicaid. Eligibility for participation in these programs depends upon a variety of factors, including, among others, accommodations, services, equipment, patient care, safety, physical environment and the implementation and maintenance of cost controls and accounting procedures. In addition, some of the Company's centers have entered into separate contracts with the United States Veterans Administration which provides reimbursement for care to veterans transferred from Veterans Administration hospitals. Historically, government health care reimbursement programs make payments under a cost based reimbursement system. Although general similarities exist due to federal mandates, each state operates under its own specific system. Medicare, however, is uniform nationwide and pays, as defined by the program, the reasonable direct and indirect cost of services furnished to Medicare patients, including depreciation, interest and overhead. Medicare payments have previously been limited by ceilings which, pursuant to the 1993 Tax Reform Act, were frozen at their 1993 level for 1994, and 1995. During 1998, the Company had 48 owned or leased centers which operated at
Medicare costs higher than the ceiling. The Company will file "exception requests" with the fiscal intermediary for substantially all of these centers. Revenues therefrom will not be booked until paid and audited by the appropriate payors. Private paying patients, private insurance carriers and the Veterans Administration generally pay on the basis of the center's charges or specifically negotiated contracts. Average per capita daily room and board revenue from private paying patients is higher than from Medicare and Medicaid patients, while the average per capita daily revenue from Medicare patients is higher than from Medicaid patients. The Company attempts to attract an increased percentage of private and Medicare patients by providing rehabilitative services and increasing its marketing of those services through market areas and "Managed Care Offices", of which seven were open at year end. These services are designed to speed the patient's recovery and allow the patient to return home as soon as is practical. In addition to educating physicians and patients to the advantages of the rehabilitative services, the Company also has implemented incentive programs which provide for the payment of bonuses to its regional and center personnel if they are able to obtain private and Medicare goals at their centers. Commencing January 1, 1999, substantially all of NHC's centers will be reimbursed for Medicare patients under the new "Prospective Payment System". Under this system, the center receives a fixed payment which covers all but a few services provided to Medicare patients. Thus the center must not only cover its fixed and normal operating expenses out of this payment, but also physical and speech therapy, drugs and other supplies, and other necessary services of the type provided by skilled nursing facilities. The Company projects a decrease in Medicare revenue of approximately $16,000,000 in 1999 due to this new system, and thus must aggressively reduce operating expenses. Material reductions have already been negotiated in therapy, pharmaceutical and other services. Medicare patients are entitled to have payment made on their behalf to a skilled nursing facility for up to 100 days during each calendar year and a prior 3-day hospital stay is required. A patient must be certified for entitlement under the Medicare program before the skilled nursing facility is entitled to receive Medicare payments and patients are required to pay approximately $95.50 per day after the first 20 days of the covered stay. For details see the section "Health Care Reform". Medicaid programs provide funds for payment of medical services obtained by "medically indigent persons". These programs are operated by state agencies which adopt their own medical reimbursement formulas and standards, but which are entitled to receive supplemental funds from the federal government if their programs comply with certain federal government regulations. In all states in which the Company operates, the Medicaid programs authorize reimbursement at a fixed rate per day of service. The fixed rate is established on the basis of a predetermined average cost of operating nursing centers in the state in which the facility is located or based upon the center's actual cost. The rate is adjusted annually based upon changes in historical costs and/or actual costs and a projected cost of living factor. The 1997 Balanced Budget Act eliminated a federally mandated requirement that Medicaid rates paid by the states must be sufficient to reimburse in full the costs of an "efficiently and reasonably operated" nursing home (the "Boron Amendment"). The Company and the nursing home industry in general are concerned about this deletion and are monitoring the activities in state legislature budgetary processes.
During the fiscal year, each facility receives payments under the applicable government reimbursement program. Medicaid payments are generally "prospective" in that the payment is based upon the prior years actual costs. Medicare payments were "retrospective" thru 1998 in that current year payments were designed to reasonably approximate the facility's reimbursable costs during that year. Payments under Medicare for years thru 1998 were adjusted to actual allowable costs each year. The actual costs incurred and reported by the facility under the Medicare program were and are subject to audit with respect to proper application of the various payment formulas. These audits can result in retroactive adjustments of interim payments received from the program. If, as a result of such audits, it is determined that overpayment of benefits were made, the excess amount must be repaid to the government. If, on the other hand, it is determined that an underpayment was made, the government agency makes an additional payment to the operator. The Company books as receivables the amounts which it expects to receive under the Medicare and Medicaid programs and books into profit or loss any differences in amounts actually received. To date, adjustments have not had a material adverse effect on the Company. The Company believes that its payment formulas have been properly applied and that any future adjustments will not be materially adverse. Effective January 1, 1999, and as discussed above, the Medicare program has become prospective in nature. For additional discussion see "Health Care Reform". In November 1996, two NHC managed facilities in Florida were audited by representatives of the regional office of the Office of Inspector General ("OIG"). As part of these audits, the OIG reviewed various records of the facilities relating to allocation of nursing hours and contracts with outside suppliers of services. The OIG completed its audit of one facility, and indicated during an exit conference that it had no further questions. At the second facility, the OIG determined certain records were insufficient and NHC is in the process of supplying additional information. The OIG has agreed to review these additional documents when received. Florida is one of the states in which governmental officials are conducting Operation Restore Trust, a federal-state program aimed at detecting and eliminating fraud and abuse by providers in the Medicare and Medicaid Programs. The OIG has increased its investigative actions in Florida as a part of Operation Restore Trust. NHC will continue to monitor the progress of this audit and cannot predict whether the OIG will take further action or request additional information as a result of either of these audits. A so-called "whistleblower" lawsuit is also outstanding against the Company. For further information, see "Item 3: Legal Proceedings". Regulation Health care centers are subject to extensive federal, state and in some cases, local regulatory, licensing, and inspection requirements. These requirements relate, among other things, to the adequacy of physical buildings and equipment, qualifications of administrative personnel and nursing staff, quality of nursing provided and continued compliance with laws and regulations relating to the operation of the centers. In all states in which the Company operates, before the facility can make a capital expenditure exceeding certain specified amounts or construct any new long-term health care beds, approval of the state health care regulatory agency or agencies must be obtained and a Certificate of Need issued. The appropriate state health planning agency must determine that a need for the new beds or expenditure exists before a Certificate of Need can be issued. A Certificate of Need is generally issued
for a specific maximum amount of expenditure and the project must be completed within a specific time period. There is no advance assurance that the Company will be able to obtain a certificate of need in any particular instance. In some states, approval is also necessary in order to purchase existing health care beds, although the purchaser is normally permitted to avoid a full scale certificate of need application procedure by giving advance written notice of the acquisition and giving written assurance to the state regulatory agency that the change of ownership will not result in a change in the number of beds or the services offered at the facility. While there are currently no significant legislative proposals to eliminate certificates of need pending in the states in which the Company does business, deregulation in the certificate of need area would likely result in increased competition among nursing home companies and could adversely affect occupancy rates and the supply of licensed and certified personnel. Health Care Reform Government at both the federal and state levels has continued in its efforts to reduce, or at least limit the growth of, spending for health care services, including the type of services provided by NHC. On August 5, 1997, President Clinton signed into law the Balanced Budget Act of 1997 ("BBA"), which contains numerous Medicare and Medicaid cost-saving measures, as well as new anti-fraud provisions. The BBA has been projected to save $115 billion in Medicare spending over the next five years, and $13 billion in the Medicaid program. Section 4711 of BBA, entitled "Flexibility in Payment Methods for Hospital, Nursing Facility, ICF/MR, and Home Health Services", repealed the Boren Amendment, which has required that state Medicaid programs pay to nursing home providers amounts adequate to enable them to met government quality and safety standards; the Boren Amendment was previously the foundation of litigation by nursing homes seeking rate increases. In place of the Boren Amendment, the BBA requires only that, for services and items furnished on or after October 1, 1997, a state Medicaid program must provide for a public process for determination of Medicaid rates of payment for nursing facility services, under which proposed rates, the methodologies underlying the establishment of such rates, and justifications for the proposed rates are published, and which give providers, beneficiaries and other concerned state residents a reasonable opportunity for review and comment on the proposed rates, methodologies and justifications. Several of the states in which NHC operates are actively seeking ways to reduce Medicaid spending for nursing home care by such methods as capitated payments and substantial reductions in reimbursement rates. The BBA also requires that nursing homes transition to a prospective payment system under the Medicare program during a three-year "transition period" commencing with the first cost reporting period beginning on or after July 1, 1998. Substantially all the companies operating skilled nursing centers commenced receiving Medicare payments under this new program on January 1, 1999. In addition, the BBA creates a managed care Medicare Program called "Medicare + Choice", which allows Medicare beneficiaries to participate in either the original Medicare fee-for-service program or to enroll in coordinated care plans such as health maintenance organizations ("HMOs"). Such coordinated care plans would allow HMOs to enter into risk-based contracts with the Medicare program, and the HMO's would then contract with providers such as the Company. No assurances can be given that the facilities to be operated by the Company will be successful in negotiating favorable contracts with Medicare + Choice managed care organizations. The BBA also
contains several new antifraud provisions. Given the recent enactment of the BBA, the Company is unable to predict the impact of the BBA and potential changes in state Medicaid reimbursement methodologies on its operations; however, any significant reduction in either Medicare or Medicaid payments could adversely affect the Company. Changes in certification and participation requirements of the Medicare and Medicaid programs have restricted, and are likely to continue to restrict further, eligibility for reimbursement under those programs. Failure to obtain and maintain Medicare and Medicaid certification at the Company's facilities will result in denial of Medicare and Medicaid payments which could result in a significant loss of revenue to the Company. In addition, private payors, including managed care payors, increasingly are demanding that providers accept discounted fees or assume all or a portion of the financial risk for the delivery of health care services. Such measures may include capitated payments whereby the Company is responsible for providing, for a fixed fee, all services needed by certain patients. Capitated payments can result in significant losses if patients require expensive treatment not adequately covered by the capitated rate. Efforts to impose reduced payments, greater discounts and more stringent cost controls by government and other payors are expected to continue. For the fiscal year ended December 31, 1998, NHC derived 38% and 33% of its net patient revenues from the Medicare and Medicaid programs, respectively. Any reforms that significantly limit rates of reimbursement under the Medicare and Medicaid programs, therefore, could have a material adverse effect on the Company's profitability. The Company is unable to predict what reform proposals or reimbursement limitations will be adopted in the future or the effect such changes will have on its operations. No assurance can be given that such reforms will not have a material adverse effect on the Company, although the Company has the goal of reducing its Medicare operating expenses to at least cover the expected 1999 Medicare revenue reductions. Nursing homes and home health agencies have recently been the target of health care reform, from both fraud and reimbursement perspectives. Operation Restore Trust, a demonstration project which has been conducted by the Department of Health and Human Services in five states, is expanding to a dozen more states. "ORT Plus" will continue its focus on fraud in the areas of home health, nursing home and DME suppliers, as well as adding new anti- fraud and abuse targets. The Company will operate nursing homes and home health agencies in five ORT Plus states and could be subject to increased scrutiny. Although NHC's management believes that its home care and nursing home operations are in compliance with applicable laws and regulations, there can be no assurance that the Company, its home care and nursing home operations will not be the subject of an investigation nor that they will be found to be in compliance if investigated. See "Item 3-Legal Proceedings". Other Business and Properties A. Nutritional Support Services. The Company owns a medical support services business, which primarily provides nutritional enteral, parenteral feeding materials, urological and medical supplies to patients in the Company's facilities as well as in other long-term care or home settings. This company is headquartered in Knoxville, Tennessee and is known as Nutritional Support Services (NSS). Revenues from this subsidiary accounted for from 4.0% to 5.6% of the Company's net revenues in 1998, 1997 and 1996.
B. Medical Specialty Units. The Company has required all of its centers to participate in the Medicare program since 1973, and has continually expanded its range of offerings by the creation of center-specific medical specialty units such as the Company's 21 Alzheimer's disease care units and 17 subacute nursing units. The services are actually provided not only at each NHC operated center, but also at existing specialized care units. C. Pharmacy Operations. The Company's policy has been to have an in-house pharmacy located in each health care center in those states where licensure permits the operation of an in-house pharmacy. In other states, pharmaceutical services have been provided by third party contracts. NHC is now creating wholly owned regional pharmacy operations and currently operates one in east Tennessee, one in South Carolina and two in central Florida. These regional pharmacies operate out of a central office and supply (on a separate contractual basis) pharmaceutical services and supplies which were formerly purchased by each center from local vendors. Pharmacy reimbursement under Medicare has also been shifted from direct billing by the pharmacy, to a negotiated rate structure between skilled nursing centers and the pharmacy, with the skilled nursing centers Medicare reimbursement being based upon a prospective rate not related to actual patient pharmaceutical usage. The Company anticipates decreased revenues for its pharmacy subsidiary as a result. The regional pharmacy operations had 8,119 nursing home beds under contract by December 31, 1998. D. Advisory Services to National Health Investors, Inc. In 1991, the Company formed National Health Investors, Inc., as a wholly-owned subsidiary. It then transferred to NHI certain healthcare facilities then owned by NHC and then distributed the shares of NHI to NHC's unitholders. The distribution had the effect of separating NHC and NHI into two independent public companies. As a result of the distribution, all of the outstanding shares of NHI were distributed to the then NHC investors. NHI entered into an Advisory, Administrative Services and Facilities Agreement (the "Advisory Agreement") with NHC pursuant to which NHC provides NHI, for a fee, with investment advice, office space, personnel and other services. For its services under the Advisory Agreement, the Advisor is entitled to a base annual compensation of $1,625,000. Compensation paid to executive officers of NHI is credited against this Advisory Fee. NHC executive officers W. Andrew Adams, Robert G. Adams and Richard F. LaRoche, Jr. serve as executive officers of NHI. For 1993 and later years in which per share Funds From Operations of NHI exceed per share Funds From Operations during 1992, the $1,625,000 annual compensation increased by the same percentage that per share Funds From Operations in such later year exceed those in 1992. NHC earned approximately $3,310,000 in 1998. The Advisory Agreement provides that the Advisor shall pay all expenses incurred in performing its obligations thereunder, without regard to the amount of compensation received under the Agreement. Expenses specifically listed as expenses to be borne
by the Advisor without reimbursement include: the cost of accounting, statistical or bookkeeping equipment necessary for the maintenance of NHI's books and records; employment expenses of the officers and directors and personnel of the Advisor and all expenses. E. Advisory Services to National Health Realty, Inc. In 1997, the Company formed National Health Realty, Inc., as a wholly-owned subsidiary. It then transferred to NHR certain healthcare facilities then owned by NHC and then distributed the shares of NHR to NHC's shareholders. The distribution had the effect of separating NHC and NHR into two independent public companies. As a result of the distribution, all of the outstanding shares of NHR were distributed to the then NHC investors. NHC has entered into an Advisory Agreement with NHR whereby services related to investment activities and day-to-day management and operations are provided to NHR by NHC as Advisor. The Advisor is subject to the supervision of and policies established by NHR's Board of Directors. Either party may terminate the Advisory Agreement on 90 days notice at any time after January 1, 2000. NHR may terminate the Advisory Agreement for cause at any time. For its services under the Advisory Agreement, NHC is entitled to annual compensation of the greater of 2% of NHR's gross consolidated revenues or the actual expenses incurred by NHC. NHC received $471,000 for its services to NHR in 1998. The Advisory Agreement provides that prior to the earlier to occur of (i) termination, for any reason, of the Advisory Agreement or (ii) NHC ceasing to be actively engaged as the investment advisor for NHI, NHR will not (without the prior approval of NHI) transact business with any party, person, company or firm other than NHC. It is the intent of the foregoing restriction that NHR will not be actively or passively engaged in the pursuit of additional investment opportunities, but rather will focus upon its capacities as landlord and note holder of those certain assets conveyed to it. F. Managed Care Contracts. The Company has identified a number of potential regional offices, which will be staffed by experienced case managers contracting with health maintenance organizations (HMO's) and insurance carriers for the provision of subacute and other medical specialty services within its regional cluster of centers. Seven case managers were in place by year end 1997. Managed care days have increased from 50,113 in 1996 and 71,606 in 1997 to 81,099 in 1998. G. Principal Office. The Company maintains its home office staff in Murfreesboro, Tennessee in a building owned by a limited partnership, which is 69.7% owned by NHC.
Competition In most of the communities in which the health care centers are operated by the Company, there are other health care centers with which the Company competes. The Company operates 108 long-term health care facilities, all of which are located in the states of Alabama, Florida, Georgia, Indiana, Kentucky, Missouri, South Carolina, Tennessee and Virginia. Each of these states are certificate of need states which generally requires the state to approve the opening of any new long-term health care facilities. There are hundreds of operators of long-term health care facilities in each of these states and no single operator, including the Company, dominates any of these state's long-term health care markets, except for some small rural markets which might have only one long-term health care facility. In competing for patients and staff with these centers, the Company depends upon referrals from acute care hospitals, physicians, residential care facilities, church groups and other community service organizations. The reputation in the community and the physical appearance of the Company's health care centers are important in obtaining patients, since members of the patient's family generally participate to a greater extent in selecting health care centers than in selecting an acute care hospital. The Company believes that by providing and emphasizing rehabilitative as well as skilled care services at its centers, it will be able to broaden is patient base and to differentiate its centers from competing health care centers. As the Company expands into the assisted living market, it constantly monitors proposed or existing competing assisted living centers. The Company's development goal is to link its health care centers with its assisted living centers, thereby obtaining a competitive advantage for both. In certain markets where the Company operates health care centers, the Company believes the assisted living centers in the area to be sufficient or over sufficient for current population, and does not plan current entry in those markets. The Company experiences competition in employing and retaining nurses, technicians, aides and other high quality professional and non-professional employees. In order to enhance its competitive position, the Company has an educational tuition loan program, an American Dietary Association approved internship program, a specially designed nurse's aide training class, and makes financial scholarship aid available to physical therapy vocational programs and The Foundation for Geriatric Education. The Company also maintains an "Administrator in Training" course, 24 months in duration, for the professional training of administrators. Presently, the Company has 11 full-time individuals in this program. Three of its eight regional vice presidents and 55 of its 106 health care center administrators have graduated therefrom. NHC's employee benefit package offers a tuition reimbursement program. The goal of the program is to insure a well trained qualified work force to meet future demands. While the program is offered to all disciplines, special emphasis has been placed on supporting students in nursing and physical therapy programs. Students are reimbursed at the end of each semester after presenting tuition receipts and grades to management. The program has been successful in providing a means for many bright students to pursue a formal education.
Employees As of December 31, 1998, the Company's Administrative Services Contractor plus the Company's managed centers had approximately 16,017 full and part time employees, who are called "Partners" by the Company. This nomenclature continues even though the Company is now in corporate rather than partnership form. No employees are presently represented by a bargaining unit. The Company believes its current relations with its employees are good.
<TABLE> <CAPTION> ITEM 2 PROPERTIES LONG-TERM HEALTH CARE CENTERS Total Beds under Development Joined State City Center Affiliation Beds and Special Care Units NHC - ----- ---- ------ ----------- ----- ---------------------- ------ <S> <C> <C> <C> <C> <C> <C> Alabama Anniston NHC HealthCare, Anniston Leased 151<F1> 50 bed Alzheimer's unit 1973 10 bed subacute care unit Moulton NHC HealthCare, Moulton Leased 136<F1> 1973 Florida Brooksville Brooksville Nursing Manor Managed 180 30 bed Alzheimer's unit 1993 Clearwater Palm Garden of Clearwater Managed<F3> 120 1987 Coconut Creek NHC HealthCare, Coconut Creek Leased<F2> 120 1997 Crystal River Cypress Cove Care Center Managed 120 1993 Dade City Royal Oak Nursing Center Managed 120 1993 Daytona Beach NHC HealthCare, Daytona Bch Leased<F2> 60 10 bed subacute care unit 1996 Ft. Lauderdale NHC of Ft. Lauderdale Managed 169 1984 Gainesville Palm Garden of Gainesville Managed<F3> 120 28 bed subacute care unit 1987 Hudson Bear Creek Nursing Center Managed 120 1993 Hudson NHC HealthCare, Hudson Leased<F1> 180 50 bed subacute care unit 1986 Jacksonville Palm Garden of Jacksonville Managed<F3> 120 1990 Lake City Palm Garden of Lake City Managed<F3> 120 28 bed Alzheimer's unit 1992 Largo Palm Garden of Largo Managed<F3> 140 1987 Largo Palm Garden of Pinellas Managed<F3> 120 36 bed subacute care unit 1991 Madison Lake Park of Madison Managed 99 20 beds under development 1995 Merritt Island NHC HealthCare, Merritt Is. Leased<F1> 180 31 bed Alzheimer's unit 1990 17 bed subacute care unit Miami The Nursing Center at Mercy Managed 120 1995 Naples NHC HealthCare, Imperial Leased<F2> 90 4 beds under development 1994 Naples NHC HealthCare, Naples Leased<F2> 60 1996 New Pt. Richey Heather Hill Nursing Home Managed 120 1993 Niceville The Manor at Blue Water Bay Managed 120 20 bed Alzheimer's unit 1993 N. Miami Beach Palm Garden of N. Miami Bch Managed<F3> 120 1988 Ocala Palm Garden of Ocala Managed<F3> 180 60 bed subacute care unit 1987 Ocoee Ocoee Health Care Center Managed 120 1990 Orlando Palm Garden of Orlando Managed<F3> 120 1987 Orlando NHC HealthCare, Orlando Leased<F2> 120 30 bed Alzheimer's unit 1997 Palatka Palatka Health Care Center Managed 180 20 bed Alzheimer's unit 1989 Panama City NHC of Panama City Managed 120 1986 Pensacola Palm Garden of Pensacola Managed<F3> 180 22 bed Alzheimer's unit 1987 14 bed subacute care unit
Plant City NHC HealthCare, Plant City Leased<F1> 172 8 beds under development 1985 Port Charlotte NHC HealthCare, Pt Charlotte Leased<F2> 180 60 bed subacute care unit 30 bed Alzheimer's unit 1994 Port St. Lucie Palm Garden of Port St. Lucie Managed<F3> 120 1988 St. Cloud Osceola Health Care Center Managed 120 1991 St. Petersburg NHC HealthCare, St. Pete Managed 159 60 bed Alzheimer's unit 1984 Sarasota Sarasota Health Care Center Managed 120 1990 Stuart NHC HealthCare, Stuart Leased<F1> 118 24 bed Alzheimer's unit 1989 35 beds under development Sun City Palm Garden of Sun City Managed<F3> 120 1991 Tampa Palm Garden of Tampa Managed<F3> 120 1987 Trenton Medic-Ayers Nursing Center Managed 120 30 bed Alzheimer's unit 1993 Vero Beach Palm Garden of Vero Beach Managed<F3> 180 1987 W. Palm Beach Palm Garden of W. Palm Beach Managed<F3> 162 1988 Winter Haven Palm Garden of Winter Haven Managed<F3> 120 1987 Georgia Ft Oglethorpe NHC HealthCare, Ft Oglethorpe Owned<F4> 135 1989 Rossville NHC HealthCare, Rossville Leased<F1> 112 1971 Indiana Brownsburg Brownsburg Health Care Center Managed 178 20 bed Alzheimer's unit 1990 Castleton Castleton Health Care Center Managed 120 60 bed Alzheimer's unit 1990 Ladoga Ladoga Health Care Center Managed 95 1990 Plainfield Plainfield Health Care Center Managed 199 57 bed Alzheimer's unit 1990 Kentucky Dawson Springs NHC HealthCare, Dawson Springs Leased<F1> 80 1973 Glasgow NHC HealthCare, Glasgow Leased<F1> 206 1971 Madisonville NHC HealthCare, Madisonville Leased<F1> 94 1973 Missouri Desloge NHC HealthCare, Desloge Leased<F1> 120 1982 Joplin NHC HealthCare, Joplin Leased<F1> 126 1982 Kennett NHC HealthCare, Kennett Leased<F1> 170 1982 Macon Macon Health Care Center Managed 120 24 bed Alzheimer's unit 1982 Osage Beach Osage Beach Health Care Center Managed 120 24 bed Alzheimer's unit 1982 St. Charles NHC HealthCare, St. Charles Leased<F1> 120 1982 St. Louis NHC HealthCare, Maryland Hghts Leased<F1> 220 30 bed Alzheimer's unit 1987 Springfield Springfield Health Care Center Managed 120 1982 West Plains West Plains Health Care Center Leased<F2> 120 1982
South Carolina Aiken Mattie C. Hall Health Care Center Managed 176 44 bed Alzheimer's unit 1982 Anderson NHC HealthCare, Anderson Leased<F1> 290 44 bed subacute care unit 1973 Clinton NHC HealthCare, Clinton Leased<F2> 131 1993 Columbia NHC HealthCare, Parklane Leased<F2> 120 30 bed Alzheimer's unit 1997 17 bed subacute care unit Greenwood NHC HealthCare, Greenwood Leased<F1> 152 1973 Greenville NHC HealthCare, Greenville Leased<F2> 176 1992 Laurens NHC HealthCare, Laurens Leased<F1> 176 1973 Lexington NHC HealthCare, Lexington Leased<F2> 120 12 bed subacute care unit 1994 Mauldin NHC HealthCare, Mauldin Leased<F2> 120 30 bed subacute care unit 1997 Murrells Inlet NHC HealthCare, Garden City Leased<F2> 88 1992 North Augusta NHC HealthCare, North Augusta Leased<F2> 132 1991 Sumter NHC HealthCare, Sumter Managed 123 15 beds under development 1985 Tennessee Athens NHC HealthCare, Athens Leased<F1> 98 1971 Carthage Smith Co. Health Care Center Managed 128 1997 Chattanooga NHC HealthCare, Chattanooga Leased<F1> 212 20 bed sub-acute care 1971 Six beds under development Columbia NHC HealthCare, Columbia Leased<F1> 120 12 bed subacute care unit 1973 Columbia NHC HealthCare, Hillview Leased<F1> 98 1971 Columbia Maury Regional Hospital Managed 20 1997 Cookeville NHC HealthCare, Cookeville Managed 96 1975 Dickson NHC HealthCare, Dickson Leased<F1> 197 1971 Dunlap NHC HealthCare, Sequatchie Leased<F1> 120 1976 Farragut NHC HealthCare, Farragut Managed 60 1998 Franklin Franklin Manor Leased<F2> 47 1997 Franklin NHC HealthCare, Franklin Leased<F1> 84 1979 Hendersonville NHC HealthCare, Hendersonville Leased<F1> 117 1987 Johnson City NHC HealthCare, Johnson City Leased<F1> 179 16 bed subacute unit 1971 Knoxville NHC HealthCare, Fort Sanders Owned<F4> 180 12 bed subacute unit 1977 Knoxville NHC HealthCare, Knoxville Leased<F1> 152 1971 Lawrenceburg NHC HealthCare, Lawrenceburg Managed 97 1985 Lawrenceburg NHC HealthCare, Scott Leased<F1> 62 1971 Lewisburg NHC HealthCare, Lewisburg Leased<F1> 104 1971 Lewisburg NHC HealthCare, Oakwood Leased<F1> 62 1973 McMinnville NHC HealthCare, McMinnville Leased<F1> 150 1971 Milan NHC HealthCare, Milan Leased<F1> 129 1971 Murfreesboro AdamsPlace Leased<F2> 40 20 beds under development 1997 Murfreesboro NHC HealthCare, Murfreesboro Managed 190 69 bed subacute care unit 1974
Nashville The Health Center of Richland Place Managed 98 8 beds under development 1992 Nashville NHC HealthCare, Nashville Leased<F1> 133 1975 Nashville West Meade Place Managed 120 1993 Oak Ridge NHC HealthCare, Oak Ridge Managed 130 1977 Pulaski NHC HealthCare, Pulaski Leased<F1> 104 1971 Smithville NHC HealthCare, Smithville Leased<F1> 107 1971 Somerville NHC HealthCare, Somerville Leased<F1> 72 1976 Sparta NHC HealthCare, Sparta Leased<F1> 150 1975 Springfield NHC HealthCare, Springfield Leased<F1> 112 1973 Virginia Bristol NHC HealthCare, Bristol Leased<F1> 120 1973 <CAPTION> ASSISTED LIVING UNITS State City Center Affiliation Assisted Living Units - ----- ---- ------ ----------- ---------------------- <S> <C> <C> <C> <C> Alabama Anniston NHC Place/Anniston (free-standing) Leased<F2> 68 bed assisted living unit Florida Merritt Island NHC Place/Merritt Island (free-standing) Leased<F2> 84 bed assisted living unit Naples NHC HealthCare, Imperial Leased<F1> 11 bed assisted living unit Naples NHC HealthCare, Naples Leased<F1> 36 bed assisted living unit Stuart NHC Place/Stuart (free-standing) Leased<F2> 84 bed assisted living unit Vero Beach NHC Place/Vero Beach (free-standing) Leased<F2> 84 bed assisted living unit West Palm Beach Palm Garden of West Palm Beach Managed<F3> 25 bed assisted living unit Missouri St. Charles Lake St. Charles Retirement Center Leased<F1> 25 bed assisted living unit St. Peters NHC Place (free-standing) 100 bed assisted living unit Tennessee Dickson NHC HealthCare Leased<F1> 20 bed assisted living unit Farragut NHC Place, Farragut Managed 84 bed assisted living unit Johnson City NHC HealthCare Leased<F1> 15 bed assisted living unit Murfreesboro AdamsPlace (free-standing) Leased<F2> 84 bed assisted living unit Nashville Richland Place Managed 32 bed assisted living unit Smithville NHC HealthCare 10 bed assisted living unit Somerville NHC HealthCare Leased<F1> 12 bed assisted living unit
<CAPTION> RETIREMENT APARTMENTS State City Retirement Apartments Affiliation Units Established - ----- ---- --------------------- ----------- ----- ----------- <S> <C> <C> <C> <C> <C> Missouri St. Charles Lake St. Charles Retirement Apartments Leased(1) 155 1984 Tennessee Chattanooga Parkwood Retirement Apartments Leased(1) 32 1986 Johnson City Colonial Hill Retirement Apartments Leased(1) 63 1987 Murfreesboro AdamsPlace Leased(2) 58 1997 Nashville Richland Place Retirement Apartments Managed 137 193 <CAPTION> HOMECARE PROGRAMS State City Homecare Programs Affiliation Established - ----- ---- ----------------- ----------- ----------- <S> <C> <C> <C> <C> Florida Blountstown NHC HomeCare of Blountstown Owned 1994 Carrabelle NHC HomeCare of Carrabelle Owned 1994 Chipley NHC HomeCare of Chipley Owned 1994 Crawfordville NHC HomeCare of Crawfordville Owned 1994 Madison NHC HomeCare of Madison Owned 1994 Marianna NHC HomeCare of Marianna Owned 1994 Ocala NHC HomeCare of Ocala Owned 1996 Panama City NHC HomeCare of Panama City Owned 1994 Perry NHC HomeCare of Perry Owned 1994 Port St. Joe NHC HomeCare of Port St. Joe Owned 1994 Quincy NHC HomeCare of Quincy Owned 1994 Stuart NHC HomeCare of Stuart Owned 1996 Tallahassee NHC HomeCare of Tallahassee Owned 1994 Vero Beach NHC HomeCare of Vero Beach Owned 1997 South Carolina Aiken NHC HomeCare of Aiken Owned 1996 Greenwood NHC HomeCare of Greenwood Owned 1996 Laurens NHC HomeCare of Laurens Owned 1996 Tennessee Athens NHC HomeCare of Athens Owned 1984 Chattanooga NHC HomeCare of Chattanooga Owned 1985 Columbia NHC HomeCare of Columbia Owned 1977 Cookeville NHC HomeCare of Cookeville Owned 1976 Dickson NHC HomeCare of Dickson Owned 1977 Johnson City NHC HomeCare of Johnson City Owned 1978 Kingsport NHC HomeCare of Kingsport Owned 1997 Knoxville NHC HomeCare of Knoxville Owned 1977
<CAPTION> HOMECARE PROGRAMS State City Homecare Programs Affiliation Established - ----- ---- ----------------- ----------- ----------- <S> <C> <C> <C> <C> Tennessee Lawrenceburg NHC HomeCare of Lawrenceburg Owned 1977 Lebanon NHC HomeCare of Lebanon Owned 1997 Lewisburg NHC HomeCare of Lewisburg Owned 1977 McMinnville NHC HomeCare of McMinnville Owned 1976 Milan NHC HomeCare of Milan Owned 1977 Murfreesboro NHC HomeCare of Murfreesboro Owned 1976 Pulaski NHC HomeCare of Pulaski Owned 1985 Somerville NHC HomeCare of Somerville Owned 1983 Sparta NHC HomeCare of Sparta Owned 1984 Springfield NHC HomeCare of Springfield Owned 1984 <FN> <F1> Leased from NHR <F2> Leased from NHR <F3> Managed by NHC for FCC. NHC anticipates that 14 of these management contracts will be terminated in 1999 and two of the FCC managed centers will be purchased by NHC in 1999. See "Legal Proceedings." <F4> NHC HealthCare/Fort Oglethorpe and NHC HealthCare/Fort Sanders are owned by separate limited partnerships. The Company owns approximately 80% of the partnership interest in Fort Oglethorpe and 25% of the partnership interest in Fort Sanders. </TABLE>
ITEM 3 LEGAL PROCEEDINGS In March 1996, Florida Convalescent Centers, Inc. (FCC), an independent Florida corporation for whom NHC manages sixteen licensed nursing centers in Florida, gave NHC notice of its intent not to renew a management contract at one of the centers. NHC responded by denying that FCC had that right. FCC then filed a Declaratory Judgment suit in the Circuit Court of the Twelfth Judicial Circuit in and for Sarasota County, Florida, requesting that the court interpret the parties' rights under their contractual arrangements, and naming NHC and its then general partners as defendants. Once the suit was filed, FCC amended its complaint four times, each amendment asserting new reasons why NHC's management agreements should be terminated. After lengthy pretrial proceedings, a jury was impaneled on October 28, 1998, but before opening arguments, the parties settled the litigation as follows: Under the terms of the settlement, NHC will purchase, subject to regulatory approval, two of the 16 long-term health care centers it currently manages for FCC in exchange for all of NHC's rights in deferred contingency fees receivable from FCC and for the assumption of approximately $14.3 million of long term debt. Additionally, NHC will pay a one-time cash settlement of $15 million. Furthermore, NHC has agreed to pay any adjustment to previously filed Medicare cost reports and routine cost limit exception requests related to these 16 centers and will be entitled to amounts received therefrom. NHC has also assumed certain additional liabilities from FCC, including contingencies related to ongoing litigation with former or current residents of FCC's centers. Under the terms of the settlement, FCC has the right to cancel the management contracts for the remaining 14 centers, which cancellation may occur no earlier than June 30, 1999. The loss of the management contract and related revenues from these 14 facilities will have a material negative impact on NHC's results of operations, even after taking into consideration the purchase of two of the 16 long-term health care centers. The two centers to be purchased by NHC are Palm Garden of Pensacola, Florida with 180 beds and Palm Garden of Lake City, Florida with 120 beds. As of December 31, 1998, the purchase of these two centers is still awaiting regulatory approval; consequently, the assets to be purchased, the liabilities to be assumed and the results of operations of these centers are not included in NHC's consolidated financial statements. NHC is also a defendant in a lawsuit styled Braeuning, et al vs. National HealthCare L.P., et al filed "under seal" in the U.S. District Court of the Northern District of Florida on April 9, 1996. The court removed the seal from the complaint - but not the file itself - on March 20, 1997, and service of process occurred on July 8, 1997, with the government participating as an intervening plaintiff. By agreement, and with court approval, the suit has been moved from the Pensacola District Court to the Tampa, Florida, District Court. NHC has filed its answer denying the allegations. The suit alleges that NHC submitted cost reports and routine cost limit exception requests containing "fraudulent allocation of routine nursing services to
ancillary service cost centers" and also alleges that NHC improperly allocated skilled nursing service hours in four managed centers, all in the state of Florida. The suit was filed under the Qui Tam provisions of the Federal False Claims Act, commonly referred to as the "Whistleblower Act". NHC has denied all allegations and believes the facts will vindicate its position. The individual plaintiff Braeuning has amended the suit to allege that he was "retaliatory discharged" from his position due to the filing of the suit. In an order (March 13, 1998) denying Braeuning's Motion for Summary Judgment on this issue, the court stated, "That the defendants have submitted a legitimate non-retaliatory reason for firing Mr. Braeuning casts significant doubt on Mr. Braeuning's likelihood of success on the merits." The individual plaintiff and defendant have currently agreed to stay any proceedings on this allegation while NHC finalizes its internal review. In regard to the initial allegations contained in the lawsuit, NHC believes that the cost report information of its centers has been either appropriately filed or, upon amendment, will reflect adjustments only for the correction of unintentional misallocations. Prior to the filing of the suit, NHC had commenced an in-depth review of the nursing time allocation process at its owned, leased and managed centers. NHC's self audit process has been approved by the plaintiffs and NHC has retained a nationally recognized accounting firm to review the self audit process. It is anticipated that all cost report years in question will be reviewed prior to there being further action in this matter at the judicial level. The cost report periods under review include periods from 1991 through 1996. Adjustments to the reimbursable cost claimed will be the responsibility of the center where costs were incurred, whether owned, leased or managed by the Company. Under the terms of NHC's settlement with FCC as discussed previously, NHC has agreed to accept any adjustments to previously filed Medicare cost reports and routine cost limit exception requests related to the 16 FCC centers. Negative adjustments to other managed centers would reduce NHC's management fee (6% of net revenue), while adjustments to owned or leased centers would directly impact the Company's financial statements. NHC intends to continue it's revenue policy of not reflecting routine cost limit exception requests as income until the process, including cost report audits, is completed. NHC will continue to fully cooperate with the government in an attempt to determine dollar amounts involved, and will and is aggressively pursuing an amicable settlement. NHC cannot predict at this time the ultimate outcome of the suit. An adverse determination in the lawsuit could subject NHC to settlements which could have a material negative impact on the financial position, results of operations and cash flows of NHC. In October 1996, two managed centers in Florida were audited by representatives of the regional office of the Office of the Inspector General ("OIG"). As part of these audits, the OIG reviewed various records of the facilities relating to allocation of nursing hours and contracts with suppliers of outside services. At one center, the OIG indicated during an exit conference that it had no further questions but has not yet issued a final report. At the second facility, which is one of four named in the Braeuning lawsuit, the OIG determined that certain records were insufficient and NHC supplied the additional requested information. These audits have been incorporated into the lawsuit. Florida is one of the states in which governmental officials are conducting "Operation Restore Trust", a federal/state program aimed at detecting and eliminating fraud and abuse by providers in the Medicare and Medicaid programs. The OIG has increased its investigative actions in Florida (and has now opened a Tennessee office) as part of Operation Restore Trust.
There is certain additional litigation incidental to NHC's business, none of which, in management's opinion, would be material to the financial position or results of operations of NHC. ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No shareholder votes were required or occurred during 1998. PART II ------- ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED UNITHOLDER MATTERS The shares of common stock of National HealthCare Corporation are traded on the American Stock Exchange under the symbol NHC. The closing price for the NHC shares on Thursday, December 31, 1998 was $15.50 and the price opened at $39.375 on January 5, 1998. On December 31, 1998, NHC had approximately 5,000 shareholders, comprised of 2,321 shareholders of record and an additional 2,679 shareholders indicated by security position listings. The following table sets out the quarterly high and low sales prices of NHC's units of partnership interest/share. The cash distributions per unit during each quarter in 1997 are shown, but NHC, as a corporation, paid no dividends during 1998. <TABLE> <CAPTION> Unit/Stock Prices Cash Distributions High Low Declared Per Unit - ------------------------------------------------------------------------- <S> <C> <C> <C> 1997 1st Quarter $47.250 $44.250 $ .60 2nd Quarter 46.188 40.750 .60 3rd Quarter 59.250 44.375 .60 4th Quarter 61.875 53.625 .60 - ------------------------------------------------------------------------- 1998 1st Quarter $41.500 $32.000 $ .00 2nd Quarter 38.500 25.250 .00 3rd Quarter 31.500 19.875 .00 4th Quarter 30.000 14.000 .00 - ------------------------------------------------------------------------- </TABLE> NHC paid cash distributions on its outstanding partnership units related to reporting years as follows: 1996, $2.16 per unit and 1997, $2.40 per unit. The Company's policy while in partnership form was to distribute 60% of its taxable income to its partners. The Company (in its corporate form) does not currently declare or pay dividends.
ITEM 6 SELECTED FINANCIAL DATA The following table represents selected financial information with respect to the Company for the five years ended December 31, 1998. This financial information has been derived from financial statements included elsewhere in this Form 10-K and should be read in conjunction with those financial statements and accompanying footnotes. NHC was a partnership through 1997, and consequently had no significant income taxes imposed upon it. <TABLE> <CAPTION> Year Ended December 31, 1998 1997 1996 1995 1994 (in thousands, except unit/share and per unit/share data) <S> <C> <C> <C> <C> <C> Operating Data: Revenue $441,214 $463,477 $386,266 $349,398 $298,192 Expenses 451,298 426,260 356,980 328,283 282,339 Income (Loss) before income taxes (10,084) 37,217 29,286 21,115 15,853 Income tax provision (benefit) (3,685) 209 --- --- --- Net income (loss) (6,399) 37,008 29,286 21,115 15,853 Earnings (Loss) per unit/share: Basic (.58) 4.17 $ 3.48 $ 2.67 $ 2.03 Diluted (.58) 3.58 2.97 2.32 1.80 Balance Sheet Data: Total assets $249,688 $239,061 $404,740 $355,491 $396,133 Long-term debt 56,311 60,227 124,678 100,871 104,243 Debt serviced by other parties 15,891 16,676 32,857 40,771 89,764 Partners' capital --- --- 128,537 108,899 101,006 Shareowners' equity 50,315 37,736 --- --- --- </TABLE> ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview-- National HealthCare Corporation ("NHC" or the "Company" and formerly National HealthCare L.P.) is a leading provider of long-term health care services. NHC operates or manages 108 long-term healthcare centers with 13,983 beds in nine states. NHC provides long-term health care services to patients in a variety of settings including long-term nursing centers, managed care specialty units, sub-acute care units, Alzheimer's care units, homecare programs, assisted living centers and independent living centers. Results of Operations-- The following table and discussion sets forth items from the consolidated statements of income as a percentage of net revenues for the audited years ended December 31, 1998, 1997 and 1996.
<TABLE> Percentage of Net Revenues <CAPTION> Year Ended December 31 1998 1997 1996 <S> <C> <C> <C> Revenues: Net patient revenues 91.6% 88.7% 88.5% Other revenues 8.4 11.3 11.5 Net revenues 100.0 100.0 100.0 Costs and Expenses: Salaries, wages and benefits 55.2 55.8 54.3 Other operating 26.7 24.1 25.4 Litigation settlement and other charges 6.4 0.0 0.0 Rent 10.4 5.7 6.4 Depreciation and amortization 2.7 3.6 3.5 Interest 1.0 2.8 2.8 Total costs and expenses 102.3 92.0 92.4 Income (Loss) Before Income Taxes (2.3)% 8.0% 7.6% </TABLE> The following table sets forth the increase in certain items from the consolidated statements of income as compared to the prior period. <TABLE> Period to Period Increase (Decrease) <CAPTION> 1998 vs. 1997 1997 vs. 1996 (dollars in thousands) Amount Percent Amount Percent <S> <C> <C> <C> <C> Revenues: Net patient revenues $ (6,704) (1.6)% $69,145 20.2% Other revenues (15,559) (29.6) 8,066 18.1 Net revenues (22,263) (4.8) 77,211 20.0 Costs and Expenses: Salaries, wages and benefits (14,977) (5.8) 48,680 23.2 Other operating 5,920 5.3 13,512 13.8 Litigation settlement and other charges 28,084 -- -- -- Rent 19,656 74.5 1,643 6.6 Depreciation & amortization (5,033) (29.9) 3,185 23.4 Interest (8,612) (66.2) 2,260 21.0 Total costs and expenses 25,038 5.9 69,280 19.4 Income (Loss) Before Income Taxes $(47,301) (127.1)% $ 7,931 27.1% </TABLE> NHC's long-term health care services, including therapy and pharmacy services, provided 94% of net revenues in 1998, 92% in 1997 and 91% in 1996. Homecare programs, which are included in the long-term care services, provided 5% of net revenues in 1998, 8% in 1997 and 9% in 1996. The overall census in owned or leased health care centers for 1998 was 90.8% compared to 92.2% in 1997 and 93.6% in 1996. The census excluding acquisitions and new openings was 92.9%, 94.4% and 93.8%, respectively, for the same periods. NHC opened 142 new owned or leased long-term care beds in 1998.
Approximately 60% (1998), 56% (1997) and 60% (1996) of NHC's net revenues are derived from Medicare, Medicaid, and other government programs. Amounts earned under these programs are subject to review by the third party payors. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. NHC generally expects final determinations to occur two to three years subsequent to the year in which amounts are earned. Any differences between estimated settlements and final determinations are reflected in operations in the year finalized. NHC has submitted various requests for exceptions to Medicare routine cost limitations for reimbursement. NHC has received approval on certain requests and others are pending approval. NHC will record revenues associated with the approved requests when such approvals, including cost report audits, are assured. 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. 1998 Compared to 1997 In 1998, NHC incurred non-recurring charges to income of $28.1 million and as a result reported a loss for the year of $10.1 million before taxes. Except for the non-recurring charges, the Company would have earned $18.0 million pre-tax net income. The non-recurring charge includes the previously announced $15.0 million pre-tax charge attributable to the settlement of the lawsuit with Florida Convalescent Centers, Inc. ("FCC"). The Company has charged earnings by an additional $13.1 million pre-tax for the assumption of liabilities, expected litigation charges and other liabilities. Year-end results for 1998 are not comparable to the prior year's results because NHC converted from a limited partnership to a corporation and spun off its real estate assets into a new company, National Health Realty, Inc. ("NHR"). Excluding the $28.1 non-recurring charge, operating results in 1998 include a 4.8% decrease compared to the same period in 1997 in net revenues and a 51.6% decrease in income before taxes. As shown in the above tables, patient revenues for NHC declined 1.6% in 1998 compared to 1997. The decline in revenues is due in part to declines in both volume of and price for rehabilitative services. Salary equivalency limits on Medicare payments for occupational and speech therapy were implemented on April 10, 1998. Also contributing to the decline in patient revenues was the implementation of Medicare's interim payment system for home health services as a result of the Balanced Budget Act of 1997. There were 329,000 homecare visits in 1998 compared to 731,000 visits in 1997. The decreased patient revenues were partially offset by the continued growth of operations. In 1998, NHC increased the number of owned or leased long-term health care beds by 142 beds from 7,382 beds to 7,524 beds. In addition, the number of owned or leased assisted living units has increased by
a net of 45 units from 729 units to 774 units. Also contributing to increased revenues in 1998 were improvements in both private pay and third party payor rates. However, with the implementation of the Medicare Prospective Payment System in 1999, payor rates are expected to decline. Other revenues declined 29.6% in 1998 and are more fully detailed in Note 6 to the consolidated financial statements. Revenues from managed centers, which are included in the consolidated statements of income in other revenues, decreased 36.0% in 1998 from $38.3 million in 1997 to $24.5 million in 1998 due primarily to decreased interest income on notes receivable of $94.4 million which were transferred to NHR on December 31, 1997. (See "Litigation" below for factors that may reduce future revenues from management services.) Decreases in salaries, wages and benefits are attributable to decreased staffing levels in therapy and homecare services and reductions in bonus and benefit programs for the year. The Company drastically reduced its bonus programs for 1998, which are based largely on profit performance. The reductions were offset in part by the increase in staffing levels due to bed additions and expansions. Also contributing to higher costs of labor are inflationary increases for salaries and the associated benefits. Operating costs have increased in part due to the increased number of beds in operation and the expansion of assisted living services. These increased beds and expansions are expected to provide increased revenues in future periods. Rent increased due primarily to rent expense on the assets transferred to NHR and leased back to NHC at the end of the previous year. Depreciation and amortization decreased as a result of the transfer of real property to NHR, offset in part by the placing of newly constructed or purchased assets in service. Interest expense decreased in 1998 compared to 1997 due to the transfer of debt to NHR and due to the capitalization of interest for assets under construction. The income tax benefit for 1998 was $3.7 million compared to $0.2 million expense in 1997. The change is due to NHC's restructure from a limited partnership to a corporation and the generation of a net operating loss carryforward in 1998. 1997 Compared to 1996 In 1997, NHC achieved strong annual growth in earnings, earnings per unit, and revenues. Net income totaled $37.0 million, a 26% increase over the comparable prior year amount. Basic earnings per unit totaled $4.17, a 20% increase. Net revenues totaled $463.5 million, a 20% increase. NHC's pre-tax net margin ratio, which is defined as pre-tax net income divided by net revenues, increased to 8.0% from 7.6% in 1996 and 6.0% in 1995, illustrating that NHC has been able to grow its revenues at a faster rate than its expenses. The growth in net patient revenues in 1997 occurred primarily in long-term healthcare center services, rehabilitative care services, and homecare services.
Improved revenues in long-term healthcare center services were due primarily to increased types and levels of services being offered and to increases in private pay and third party billing rates. Additionally, the total number of owned or leased beds increased by 721 beds from 6,661 beds at the end of 1996 to 7,382 beds at the end of 1997. During 1997 and 1996, NHC had 46 and 48, respectively, owned or leased centers which operated at Medicare costs higher than the routine cost limits. Revenues also improved during 1997 due to continued emphasis on rehabilitative care services. To boost the ability to offer physical, speech and occupational therapy to greater numbers of patients, NHC increased its staff of professionally licensed therapists by 15% to 1,155 therapists in 1997 and by 26% to 1,005 therapists in 1996. Six hundred twenty-nine (629) companies, including homecare companies, school systems, hospitals, a sports medicine company and outpatient clinics contracted for NHC's rehabilitative services in 1997, which number is up from 586 companies in 1996. Revenues from therapy services in 1997 were also enhanced by the favorable resolution of certain prior years cost report issues with fiscal intermediaries. Homecare revenues improved due to increased payor rates, offset in part by decreased numbers of visits at NHC's 36 Florida, Tennessee and South Carolina homecare locations. There were 731,000 homecare visits in 1997 compared to 754,000 visits in 1996. The decreased number of visits is due primarily to NHC's early adaptation to changes in Medicare reimbursement for home health care services brought about by the Balanced Budget Act of 1997. Other revenues, which increased 18.1% in 1997, are more fully detailed in Note 6 to the consolidated financial statements. The majority of the increase in other revenues is attributable to the increase in revenues from management services, which grew 18.5% in 1997. The revenues from management services increased due to the increased number of beds being managed for others, increased amounts and types of management and other support services being offered, and increased interest income from higher principal amounts on loans to managed centers. In 1997, four long-term care centers and 517 long-term care beds were added under new management contracts. Management fees are generally based upon a percentage of net revenues of the managed center and therefore tend to increase as a facility matures and as prices rise in general. NHC's management contracts are generally long-term (up to ten years) and include equity participation agreements and the right of first refusal upon the sale of the property. (See "Transfers to National Health Realty" and "Litigation" below for factors which may reduce future revenues from management services.) Increases in salaries, wages and benefits in 1997 are attributable to the increase in staffing levels due to long-term healthcare center bed additions, and the expansion of assisted living services, rehabilitation services and homecare services. Further contributing to higher costs of labor are inflationary increases for salaries and the associated benefits. Salaries, wages and benefits increased also due to forgiveness by NHC of the debt of certain key employees related to stock options which had been exercised in previous years. The debt forgiveness was to reward employees for prior years service and is also contingent upon the employees remaining employed with NHC through certain future dates. Labor costs are the most significant costs of NHC.
Operating costs have increased due to the increased numbers of long-term care beds in operation, the expansion of assisted living services, the expansion of rehabilitative services, the expansion of homecare services, and the growth in management services. Rent expense increased due to increases in percentage rent paid to National Health Investors, Inc. ("NHI"). Depreciation and amortization increased as a result of NHC's placing of newly constructed or purchased assets in service and due to capital improvements at existing properties. Interest expense increased due to additional borrowing for newly constructed long-term care beds and assisted living apartments. Growth and Development-- NHC plans to continue to expand its continuum of care to the elderly by offering a comprehensive range of services through related or separately structured health care centers, homecare programs, specialized care units, pharmacy operations, rehabilitative services, assisted living centers and independent living centers. During 1998, NHC grew its long-term health care business by acquiring or constructing additions totaling 142 licensed beds at six owned or leased health care centers and totaling 147 licensed beds at four managed health care centers. The growth in managed health care centers was more than offset by the discontinuance of management of 377 beds at four centers. The centers had been unable to pay for all the services performed by NHC. The total number of owned, leased or managed centers operated by NHC at the end of 1998 was 108 centers and the total number of licensed beds was 13,983. During 1999, NHC expects to finish construction on 73 beds at five owned or leased centers and 43 beds at three managed centers. NHC also has been granted governmental certificates of need to permit construction of 648 beds at six owned or leased locations and 210 beds at two managed locations which are expected to start construction during 1999. As part of its overall long-term health care continuum, NHC has also continued to expand its assisted living services. Assisted living centers provide basic room and board functions for the elderly with on-staff availability to assist in minor medical and living needs on an as needed basis. NHC currently operates 16 assisted living projects, 9 of which are located within the physical structure of a long-term care center or retirement center and seven of which are freestanding. It is expected that NHC will start construction of three additional assisted living projects with 277 units in 1999. Certificates of need are not required to build assisted living projects. Liquidity, Capital Resources and Financial Condition-- Net cash provided by operating activities was $28.5 million for the year ended December 31, 1998, as compared to $41.2 million provided by operating activities for the comparable period in 1997. Cash provided by operating activities for the year ended December 31, 1998 decreased from the comparable period in 1997 primarily as a result of the decrease in net earnings after non-cash charges.
Net cash used in financing activities was $8.2 million for the year ended December 31, 1998 as compared to $34.6 million net cash provided by financing activities in 1997. In the 1997 period, the Company received proceeds from debt issuance and convertible notes of $65.3 million. In addition, in 1997 NHC made cash distributions to partners of $21.0 million. These cash distributions were reduced to $5.4 million, which had been accrued in 1997, and then discontinued in 1998 with the new "corporate" versus "partnership" structure. Net cash used by investing activities was $24.9 million for the year ended December 31, 1998, as compared to $60.6 million for the year ended December 31, 1997. Cash used for the purchase of property and equipment was $24.0 million for the year ended December 31, 1998 and $43.7 million in the comparable period in 1997. Cash collected on notes receivable, net of investments in notes receivable, was $3.4 million in 1998 compared to net cash invested for notes receivable in 1997 of $14.6 million. NHC is committed to spend approximately $1.2 million for ongoing construction contracts. NHC has also guaranteed approximately $67.9 million of the debt of certain health care centers which NHC manages for others. At December 31, 1998, NHC expects to have no additional liability as a result of its debt guarantees. NHC's current cash on hand, marketable securities, short-term notes receivable, operating cash flows and, as needed, its borrowing capacity are expected to be adequate to finance NHC's operating requirements and growth and development plans for 1999 and into 2000. For all financial instruments except the subordinated convertible notes, NHC believes that the financial statement carrying amounts approximate fair value at December 31, 1998. The fair value of the subordinated convertible notes was estimated based on quoted market prices. Two significant events occurred on December 31, 1997, which will have a permanent impact on NHC's results of operations and financial condition - the transfers to NHR and the governmentally mandated loss of partnership tax status. Transfers to National Health Realty-- As more fully described in Note 3 to the consolidated financial statements, at December 31, 1997, NHC transferred certain assets, liabilities and equity to NHR, a real estate investment trust. NHC received in exchange all of the common stock or other equity interests of NHR, which was transferred to NHC's unitholders. Concurrent with the transfers to NHR, NHC leased from NHR the real property which had been transferred. Effect of the Transfers on Results of Operations-- The effect of the transfer of assets and liabilities to NHR on results of operations is as follows. "Other revenues" have been reduced for the interest income on notes receivable transferred and operating expenses have been increased by the rent expense on the property transferred. These reductions in net income are offset in part by the reduction of interest expense on debt transferred, by the reduction of depreciation expense on assets transferred, and by the receipt of an advisory fee from NHR under an advisory agreement. The net effect of these transactions has been to reduce pre-tax net income when compared to periods prior to the transfer.
Effect of the Transfer on Liquidity and Financial Condition-- Assets transferred to NHR included mortgage notes receivable (total book value of $94.4 million), as well as the real property of 16 long-term health care centers, six assisted living facilities and one retirement center (total book value of $144.6 million) and related liabilities (total book value of $86.4 million). Equity transferred to NHR totaled $152.6 million. Although these physical assets were transferred, the operational revenues and expenses remain, as before, with NHC. Restructure from Limited Partnership to Corporation-- Under the Revenue Act of 1987, NHC and certain other similar publicly traded partnerships were permitted to be taxed as partnerships and not as corporations through December 31, 1997. However, NHC became subject to federal income taxes for taxable income generated subsequent to December 31, 1997. In response to the governmentally mandated loss of partnership tax status, the holders of NHC general and limited partnership units approved a plan of restructure whereby, on December 31, 1997, NHC converted from a limited partnership to a corporation. All partnership units outstanding on December 31, 1997 were effectively converted into shares of common stock. The restructure from a limited partnership to a corporation had no effect on the liquidity or financial condition of NHC. Cash Dividends-- NHC may pay dividends at the discretion of the Board of Directors; however, at present, NHC does not anticipate paying dividends. New Accounting Pronouncements-- In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 requires that changes in the amounts of certain items, including gains and losses on marketable securities, be shown in the consolidated financial statements. NHC retroactively adopted the provisions of SFAS 130 effective January 1, 1998. NHC has elected to disclose comprehensive income, which includes net income and unrealized gains and losses on marketable securities, in the consolidated statements of shareowners' equity and partners' capital. In April 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 98-5 ("SOP 98-5") effective for fiscal years beginning after December 15, 1998. SOP 98-5 requires that all nongovernmental entities expense the costs of start-up activities as those costs are incurred. The statement also requires nongovernmental entities to write off any unamortized start-up costs that remain on the balance sheet at the date of adoption. NHC will adopt the provisions of SOP 98-5 effective January 1, 1999. Management does not expect the adoption to have a material impact on NHC's financial position, results of operations or cash flows.
Impact of Inflation-- Inflation has remained relatively low during the past three years. In addition, historical reimbursement rates under the Medicare and Medicaid programs generally have reflected the underlying increases in health care costs and expenses resulting from inflation. For these reasons, the impact of inflation on profitability has historically not been significant. However, the vast majority of NHC's healthcare centers are required to begin the three-year phase-in of the new Prospective Payment System under the Medicare program effective January 1, 1999. Although rates to be paid during the phase-in will be based on a blend of historical costs for each center and average historical costs for all U.S. skilled nursing facilities, as adjusted for inflation, the rates to be paid are generally expected to be less than the rates paid under the former retrospective payment system. Therefore, there can be no assurance that future rate increases will be sufficient to offset future inflation increases in NHC's labor and other health care service costs. Health Care Legislation-- During 1997, the federal government enacted the Balanced Budget Act of 1997 ("BBA"), which requires that skilled nursing facilities transition to a Prospective Payment System ("PPS") under the Medicare program commencing with the first cost reporting period beginning on or after July 1, 1998. Although PPS went into effect for a small portion of NHC's long-term healthcare centers during 1998, PPS will be implemented for the vast majority of NHC's centers beginning January 1, 1999. PPS will significantly change the manner in which NHC's centers are paid for inpatient services provided to Medicare beneficiaries. Under PPS, Medicare will pay NHC's centers a fixed fee per Medicare patient per day, based on the acuity level of the patient, to cover all post-hospital extended care routine service costs, ancillary costs and capital related costs. The per diem rate will also cover substantially all items and services furnished during a covered stay for which reimbursement is currently made separately under Medicare. PPS will be phased in over a three-year period. During the phase-in, payments will be based on a blend of each center's specific historical costs and federally-established per diem rates that are based on an average of all U.S. skilled nursing facilities' historical costs. NHC has analyzed its center-specific historical costs, reviewed the expected federally-determined rates, and analyzed the current acuity level of Medicare patients in its centers. Based on such review and analyses, NHC has developed plans for each center to deliver care to Medicare patients at a lower cost and in a manner consistent with PPS requirements. These plans include a significant reduction in the number of therapy staff positions and renegotiation at lower rates of supplier contracts for inhalation therapy, pharmacy, x-ray, and medical supplies. Although NHC believes that it is positioned to operate effectively under PPS, if NHC is unable to execute the center-specific plans to reduce the cost of care to Medicare patients, PPS could have a material adverse effect on NHC's financial position, results of operations and cash flows.
Litigation-- As discussed in more detail in Note 15 to the consolidated financial statements, NHC is a defendant in a lawsuit filed under the Qui Tam provisions of the Federal False Claims Act, commonly referred to as the "Whistleblower Act", with the government participating as an intervening plaintiff. The suit alleges that NHC has submitted cost reports and routine cost limit exception requests containing "fraudulent allocation of routine nursing services to ancillary cost centers" and improper allocation of skilled nursing service hours in four managed centers. NHC is cooperating fully with the government and is aggressively pursuing an amicable settlement. An adverse determination in the lawsuit could subject NHC to repayments which could have a material negative impact on the financial position, results of operations, and cash flows of NHC. Also as discussed in more detail in Note 15 to the consolidated financial statements, NHC has settled a lawsuit filed by FCC, an independent Florida corporation for whom NHC manages 16 licensed nursing centers in Florida. Under the terms of the settlement, NHC will purchase, subject to regulatory approval, 2 of the 16 long-term healthcare centers it currently manages for FCC in exchange for all of NHC's rights in deferred contingency fees receivable from FCC and for the assumption of approximately $14.3 million of long-term debt. Additionally, NHC will pay a one-time cash settlement of $15 million. Furthermore, NHC has agreed to pay any adjustments to previously filed Medicare cost reports and routine cost limit exception requests related to these 16 centers and will be entitled to amounts received therefrom. NHC has also assumed certain additional liabilities from FCC, including contingencies related to ongoing litigation with former or current residents of FCC's centers. Under the terms of the settlement, FCC has the right to cancel the management contracts for the remaining 14 centers, which cancellation may occur no earlier than June 30, 1999. The loss of the management contract and related revenues from these 14 facilities will have a material negative impact on NHC's results of operations, even after taking into consideration the purchase of 2 of the 16 long-term healthcare centers. The two centers to be purchased by NHC are Palm Garden of Pensacola, Florida with 180 beds and Palm Garden of Lake City, Florida with 120 beds. As of December 31, 1998, the purchase of these two centers is still awaiting regulatory approval; consequently, the assets to be purchased, the liabilities to be assumed, and the results of operations of these centers are not included in NHC's consolidated financial statements. Year 2000 Compliance-- NHC has evaluated its information technology systems and embedded technology with respect to potential Year 2000 problems. Based upon current information, NHC anticipates successful completion and testing of its own Year 2000 remediation efforts during 1999. NHC does not anticipate any material disruption in its operations as a result of any failure by NHC to be in compliance. However, there can be no guarantee that the Year 2000 will not have a material adverse effect on NHC's operations, financial position or liquidity if NHC's remediation efforts are not successful or completed in a timely manner. NHC is currently developing a contingency plan in the event that it is not able to achieve Year 2000 compliance. This contingency plan is expected to include back-up processes that do not rely on computers, whenever possible.
Costs incurred to date for NHC's internal Year 2000 remediation efforts have not been material, and NHC does not expect that the cost of future internal actions will be material to its financial condition or results of operations. However, NHC also depends upon the proper functioning of information technology systems and embedded technology operated by certain other third parties. These third parties include third party payors such as the Medicare and Medicaid programs, commercial banks and other lenders, and vendors such as providers of food supplies and services, telecommunications and utilities. NHC currently is gathering information concerning the Year 2000 compliance status of these third parties. If third parties with whom NHC interacts have Year 2000 problems that are not remedied, the following problems could result: (i) in the case of third party payors - the delayed collection of accounts receivable potentially resulting in liquidity stress; (ii) in the case of banks and other lenders - the disruption of capital flows potentially resulting in liquidity stress; or (iii) in the case of vendors - the disruption of important services upon which NHC depends, such as food services and supplies, telecommunications and electrical power. ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE RISK The Company's cash and cash equivalents consist of highly liquid investments with a maturity of less than three months. As a result of the short-term nature of the Company's cash instruments, a hypothetical 10% change in interest rates would have no impact on the Company's future earnings and cash flows related to these instruments. A hypothetical 10% change in interest rates would also have an immaterial impact on the fair values of these instruments. Approximately $10 million of the Company's notes receivable bear interest at fixed interest rates. As the interest rates on these notes receivable are fixed, a hypothetical 10% change in interest rates would have no impact on the Company's future earnings and cash flows related to these instruments. A hypothetical 10% change in interest rates would also have an immaterial impact on the fair values of these instruments. Approximately $26.3 million of the Company's notes receivable bear interest at variable rates (generally at prime plus 2%). Because the interest rates of these instruments are variable, a hypothetical 10% change in interest rates would result in a related increase or decrease in interest income of approximately $260,000. However, a hypothetical 10% change in interest rates would have an immaterial impact on the fair values of these instruments. As of December 31, 1998, $30.2 million of the Company's long-term debt and debt serviced by other parties bear interest at fixed interest rates. As of December 31, 1998, all of the Company's $714,000 of convertible subordinated debentures bear interest at a fixed rate. Because the interest rates of these instruments are fixed, a hypothetical 10% change in interest rates would have no impact on the Company's future earnings and cash flows
related to these instruments. A hypothetical 10% change in interest rates would have an immaterial impact on the fair values of these instruments. The remaining $45.7 million of the Company's long-term debt and debt serviced by other parties bear interest at variable rates. Because the interest rates of these instruments are variable, a hypothetical 10% change in interest rates would result in a related increase or decrease in interest expense of approximately $275,000. However, a hypothetical 10% change in interest rates would have an immaterial impact on the fair values of these instruments. The Company does not currently use any derivative instruments to hedge its interest rate exposure. The Company has not used derivative instruments for trading purposes and the use of such instruments in the future would be subject to strict approvals by the Company's senior officers. Therefore, the Company's exposure related to such derivative instruments is not material to the Company's financial position, results of operations or cash flows. EQUITY PRICE RISK The Company considers its investments in marketable securities as available for sale securities and unrealized gains and losses are recorded in stockholders' equity in accordance with Statement of Financial Accounting Standards No. 115. The investments in marketable securities are recorded at their fair market value based on quoted market prices. Thus, there is exposure to equity price risk, which is the potential change in fair value due to a change in quoted market prices. Hypothetically, a 10% change in quoted market prices would result in a related 10% change in the fair value of the Company's investments in marketable securities.
ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following table sets forth selected quarterly financial data for the two most recent fiscal years. <TABLE> Selected Quarterly Financial Data (unaudited, in thousands, except per unit amounts) <CAPTION> 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter(A) 1998 <S> <C> <C> <C> <C> Net Revenues $114,097 $110,986 $108,454 $107,677 Net Income 2,534 2,782 2,901 (14,616) Basic Earnings Per Unit .240 .250 .260 (1.33) Diluted Earnings Per Unit .240 .250 .260 (1.33) <CAPTION> 1997 <S> <C> <C> <C> <C> Net Revenues $105,863 $106,191 $111,989 $139,434 Net Income 6,958 7,342 9,377 13,331 Basic Earnings Per Unit .790 .830 1.060 1.480 Diluted Earnings Per Unit .690 .720 .910 1.230 </TABLE> Note A: In the fourth quarter of 1997 net revenues and income were increased by approximately $4,000,000 ($.45 per unit, basic and $.36 per unit, diluted), respectively, due to enhanced retroactive Medicare and Medicaid reimbursement which, if known, would have been reported periodically throughout the year. The financial statements are included as Exhibit 13 and are incorporated in this Item 8 by reference. ITEM 9 DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no disagreements on accounting and financial disclosure.
PART III -------- ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT Directors and Executive Officers: The Company is managed by its Board of Directors, all but one of which were on the Board of Directors of the Company's Managing General Partner when the Company was organized as a public partnership (1986-1997). The Board of Directors is divided into three classes. The Directors hold office until the annual meeting for the year in which their term expires and until their successor is elected and qualified. As each of their terms expire, the successor shall be elected to a three-year term. A director may be removed from office for cause only. Officers serve at the pleasure of the Board of Directors for a term of one year. The following table sets forth the directors and the executive officers and vice presidents of the Company: <TABLE> <CAPTION> Director of Position Managing Officer of with the General Managing Company Partner or Current General or Managing Company's Term as Partner or General Predecessor Director Predecessor Name Age Partner Since Expires Since <S> <C> <C> <C> <C> <C> W. Andrew Adams 53 Chairman of the Board/ 1994(CEO) 1999 1973 President 1974(Pres.) J. K. Twilla 72 Director 1972 2001 --- Olin O. Williams 68 Director 1971 2000 --- Ernest G. Burgess, III 59 Director 1992 1999 1975 Robert G. Adams 52 S. Vice President/ Director 1993 2000 1985 Lawrence C. Tucker 56 Director 1998 2001 --- Richard F. LaRoche, Jr. 53 Sr. Vice President/ Secretary and General Counsel -- -- 1974 Charlotte Swafford 50 Treasurer -- -- 1985 Donald K. Daniel 52 Vice President/ Controller -- -- 1977 Julia W. Powell 49 Vice President/ Patient Services -- -- 1985 Joanne G. Batey 54 Vice President/ HomeCare -- -- 1989 D. Gerald Coggin 47 Vice President/ Government and Rehabilitative -- -- 1994 David L. Lassiter 44 Vice President/ Corporate Affairs -- -- 1995 Steven A. Strawn 41 Vice President/ Operations -- -- 1995 Kenneth D. DenBesten 46 Vice President/ Finance -- -- 1992 </TABLE>
Drs. Twilla and Williams were physicians in private practice in Tennessee for more than 25 years each and are now retired. Dr. Williams serves as Chairman of the Board of the Bank of Murfreesboro, Murfreesboro, Tennessee and both are Directors of National Health Realty, Inc. Mr. W. Andrew Adams has been President since 1974 and Chairman of the Board since 1994. He currently serves on the Multi-facility Committee of the American Health Care Association. He has an M.B.A. degree from Middle Tennessee State University. Mr. Adams serves on the Board of Trust of David Lipscomb University, Nashville, Tennessee, is President and Chairman of the Board of Directors of National Health Investors, Inc., and National Health Realty, Inc. and serves on the Board of SunTrust Bank in Nashville, Tennessee. Mr. Robert Adams (Senior Vice President, Chief Operating Officer and Director) has served both as an Administrator and a Regional Vice President holding the last position from 1977 to 1985. He has a B.S. degree from Middle Tennessee State University. He serves as Chief Operations Officer for the Company. He is on the Board of Directors of National Health Realty, Inc. Mr. Robert Adams and Mr. W. Andrew Adams are brothers. Mr. Burgess (Director) is retired Senior Vice President of NHC. He has an M.S. degree from the University of Tennessee. He is on the Board of Directors of National Health Realty, Inc. Mr. Tucker (Director) has been with Brown Brothers Harriman & Co. ("BBH&Co."), a private banking company, for 32 years and became a General Partner in January 1979. Mr. Tucker currently serves as a member of the Steering Committee of BBH&Co. He is responsible for the corporate finance activities of BBH&Co., including management of the 1818 Funds, private equity investing partnerships with committed capital exceeding $1.5 billion. Mr. Tucker is a director of MCI WorldCom, Inc., Riverwood International Corporation, VAALCO Energy, Inc., and the MCI WorldCom Investment Fund. Mr. Tucker has a B.S. degree from Georgia Institute of Technology and an MBA from the Wharton School of the University of Pennsylvania. Mr. LaRoche (Senior Vice President) has been Senior Vice President since 1985, Secretary since 1974 and General Counsel since 1971. He has a law degree from Vanderbilt University and an A.B. degree from Dartmouth College. His responsibilities include legal affairs, acquisitions and finance. Mr. LaRoche also serves as a director, Vice President and Secretary of National Health Investors, Inc. and as Vice President and Secretary of National Health Realty, Inc. Mr. Strawn (Vice President/Operations) has been with the Company since 1979. He trained in NHC's A.I.T. program and then served both as administrator and Regional Vice President before being appointed to the present position in 1995. He has a B.S. degree from Middle Tennessee State University. Mr. Daniel (Vice President and Controller) joined the Company in 1977 as Controller. He received a B.A. degree from Harding University and an M.B.A. from the University of Texas. He is a certified public accountant.
Mr. Lassiter (Vice President/Corporate Affairs) joined the Company in 1995. From 1988 to 1995, he was Executive Vice President, Human Resources and Administration for Vendell Healthcare. From 1980-1988, he was in human resources positions with Hospital Corporation of America and HealthTrust Corporation. Mr. Lassiter has a B.S. and an M.B.A. from the University of Tennessee. Ms. Swafford (Treasurer) has been Treasurer of the Company since 1985. She joined the Company in 1973 and has served as Staff Accountant, Accounting Supervisor and Assistant Treasurer. She has a B.S. degree from Tennessee Technological University. Ms. Powell (Vice President/Patient Services) has been with the company since 1974. She has served as a nurse consultant and director of patient assessment computerized services for NHC. Ms. Powell has a bachelor of science in nursing from the University of Alabama, Birmingham, and a master's of art in sociology with an emphasis in gerontology from Middle Tennessee State University. She co-authored Patient Assessment Computerized in 1980 with Dr. Carl Adams, the Company's founder. Ms. Batey (Vice President/Homecare) has been with the company since 1976. She served as homecare coordinator for five years before being named Vice President in 1989. Prior to that she was director of communication disorders services. Ms. Batey received her bachelor's and master's degrees in speech pathology from Purdue University. Mr. Coggin (Vice President/Governmental and Rehabilitative Services) has been employed by NHC since 1973. He has served as both Administrator and Regional Vice President before being appointed to the present position. He received a B.A. degree from David Lipscomb University and a M.P.H. degree from the University of Tennessee. He is responsible for the Company's rehabilitation, managed care and legislative activities. Mr. DenBesten (Vice President/Finance) has served as Vice President of Finance since 1992. From 1987 to 1992, he was employed by Physicians Health Care, most recently as Chief Operating Officer. From 1984-1986, he was employed by Health America Corporation as Treasurer, Vice President of Finance and Chief Financial Officer. Mr. DenBesten received a B.S. in business administration and an M.S. in Finance from the University of Arizona. The above officers serve in identical capacities for the Company and its administrative services contractor, National Health Corporation. Outside directors receive $2,500 per meeting attended. In addition, outside directors receive a stock option to purchase 10,000 shares of NHC common stock at a purchase price equal to the closing price of the Corporation Shares at the closing price on the date of the Corporation's annual meeting. There were three Board meetings during 1998 and no Board member missed a meeting.
ITEM 11 EXECUTIVE COMPENSATION Introduction: The Board of Directors have elected to continue unchanged the Company's prior compensation and bonus plans. Their goals in executive compensation and compensation at all levels within the Company are derived from the following priorities: First, to encourage the achievement of the highest levels of quality in its fields of endeavor; and second, to provide the strongest incentive possible in order to average, over a five year period, a 20% return on shareholder's equity. With these goals in mind, the Company's executive compensation program is based on employee performance rewarded as follows: (1) the achievement of a return on investment for shareholders; (2) returns generated from stock performance based incentive plans; and (3) from base salary. The following text and tables describe the various components of this plan as were attained and applied during 1998. Total Compensation: Table I sets forth certain information concerning the total compensation paid by the administrative general partner and reimbursed to it by the Company for the year ended December 31, 1998 to the three executive officers of the Company. Option Plans: At the 1994 Annual Meeting, the 1994 Option Plan was adopted and approved. A total of 1,200,000 units were reserved for issuance upon exercise of options to be granted by the Board of Directors. No options were granted to key employees during 1998, however, pursuant to the Plan, non employee directors each receive an option to purchase 10,000 shares on the date of the Annual Meeting and for the closing share price that day. 30,000 units were granted to the three non-employee Directors at $39.88 per share on March 31, 1998. At December 31, 1998, an option to purchase 5,000 units at $24.88 per share is outstanding to one director, options to purchase 15,000 shares are outstanding at $30.750 per share to three directors and options to purchase 30,000 shares are outstanding at $39.88 per share to three directors. The Company's Board of Directors and the then sole shareholder of the Company have adopted the 1997 Stock Option and Stock Appreciation Rights Plan (the "1997 Stock Option Plan"), under which options to purchase shares of the Company's common stock are available for grant to consultants, advisors, directors and employees of the Company, providing an equity interest in the Company and additional compensation based on appreciation of the value of such stock. The 1997 Stock Option Plan allows for options to purchase in the aggregate up to 1,000,000 shares of NHC common stock to be granted by the Board of Directors. The Board of Directors may, in its discretion grant incentive stock options ("ISO's"), non-qualified stock options or stock appreciation rights ("SAR's").
In addition, the 1997 Stock Option Plan provides that the non-employee directors will receive a non-qualified stock option to purchase 10,000 shares of common stock at a purchase price equal to the closing price of the Shares on the initial date of trading and will be automatically granted an option to purchase 10,000 shares of common stock annually on the date of the Company's annual meeting with an exercise price equal to the closing price on the date of such annual meeting. The 1997 Stock Option Plan provides that the exercise price of an ISO option must not be less than the fair market value of the common stock on the trading day next preceding the date of the grant. Payment for shares of common stock to be issued upon exercise of an option may be made either in cash, Company common stock or any combination thereof, at the discretion of the option holder. Options are nontransferable, other than by will, the laws of descent and distribution; assignable to family partnerships, trusts or immediate family members; or pursuant to certain domestic relations orders. Common stock subject to options granted under the 1997 Stock Option Plan that expire, terminate or are canceled without having been exercised in full become available again for option grants. The 1997 Stock Option Plan is administered by the Board of Directors, or, at the discretion of the Board of Directors, a committee of directors. Subject to certain limitations, the Board and its committee have the authority to determine the recipients, as well as the exercise prices, exercise periods, length and other terms of stock options granted pursuant to the 1997 Stock Option Plan and Company repurchase options upon termination of a recipients employment. In making such determinations, the Board may take into account the nature of the services rendered or to be rendered by option recipients, and their past, present or potential contributions to the Company. The number of shares of common stock that may be granted under the 1997 Stock Option Plan or under any outstanding options granted thereunder will be proportionately adjusted, to the nearest whole share, in the event of any stock dividend, stock split, share combination or similar recapitalization involving the common stock or any spin-off, spin-out or other significant distribution of the Company's assets to its stockholders for which the Company receives no consideration. Generally, in the event an option holder is terminated as an employee by reason of disability or death, the holder or his or her representative may exercise the option for a period of 12 months following such termination unless the Board of Directors elects, in its sole discretion, to extend the exercise period. If the employment of an option holder is terminated for "cause," as defined in the 1997 Stock Option Plan, the unexercised options expire. In the event the option holder is terminated as an employee for any reason other than disability, death or cause, the holder may not exercise his or her option unless authorized by agreement of the Company. In the event of a dissolution or liquidation of the Company or a merger or consolidation or acquisition in which the Company is not the surviving corporation, each outstanding option will become fully exercisable and each holder will have the right, within 60 days prior to such dissolution, liquidation, merger, consolidation or acquisition, to exercise his or her options, in whole or in part.
Either non-qualified or incentive stock options may be granted under the 1997 Stock Option Plan. No federal income tax consequences occur to either the Company or the optionee upon the Company's grant or issuance of a non- qualified stock option. Upon an optionee's exercise of a non-qualified stock option, the optionee will recognize ordinary income in an amount equal to the difference between the fair market value of the common stock purchased pursuant to the exercise of the option and the exercise price of the option. However, if the common stock purchased upon exercise of the option is not transferable or is subject to a substantial risk of forfeiture, then the optionee will not recognize income until the stock becomes transferable or is no longer subject to such a risk of forfeiture (unless the optionee makes an election under Internal Revenue Code Section 83(b) to recognize the income in the year of exercise, which election must be made within 30 days of the option exercise). The Company will be entitled to a deduction in an amount equal to the ordinary income recognized by the optionee in the year in which such income is recognized by the optionee. Upon a subsequent disposition of the shares of common stock, the optionee will recognize a capital gain to the extent the sales proceeds exceed the optionee's cost of the shares plus the previously recognized ordinary income. Incentive stock options granted under the 1997 Stock Option Plan are intended to qualify for a favorable tax treatment under Internal Revenue Code Section 422. No individual may be granted incentive stock options under the Corporation Stock Option Plan exercisable for the first time during any calendar year and having an aggregate fair market value in excess of $100,000. If the recipient of an incentive stock option disposes of the underlying shares before the end of certain holding periods (essentially the later of one year after the exercise date or two years after the grant date), he or she will generally recognize ordinary income in the year of disposition in an amount equal to the difference between his or her purchase price and the fair market value of the Corporation common stock on the exercise date. If a disposition does not occur until after the expiration of the holding periods, the recipient will generally recognize a capital gain equal to the excess of the disposition price over the price paid by the recipient on the exercise date. The Company generally will not be entitled to a tax deduction for compensation expense on account of the original sales to employees, but may be entitled to deduction if a participant disposes of stock received upon exercise of an incentive stock option under the 1997 Stock Option Plan prior to the expiration of the holding periods. The Company has also established several non-qualified deferred compensation plans for its key employees similar to the plans offered by NHC, one of which provides a matching contribution (15%) for all deferred compensation used to purchase shares of common stock held by an independent trustee. The matching contribution is forfeited to the Company unless the employee achieves eight years of vesting service before withdrawing funds from the Trustee account. The Company grants credit to employees for years of service with the prior partnership. Table II shows as to the three executive officers: (i) the number of shares as to which options have been granted from January 1, 1997 through December 31, 1998 under the 1994 Option Plan; (ii) the percentage of all shares granted represented by these individuals (iii) the option exercise price per share and the expiration date; and (iv) the potential realizable value of these options assuming both a five percent and ten percent share price appreciation over the next four years.
Table III identifies for the same three person group all options exercised during 1998, the value realized upon exercise, and the unrealized value of the balance of options outstanding. The Company maintains several non-qualified deferred compensation plans for its key employees, one of which provides a matching contribution (15%) for all deferred compensation used to purchase shares interest held by an independent trustee. The matching contribution is forfeited to the company unless the employee achieves eight years of vesting service before withdrawing funds from the Trustee account. Mr. LaRoche participated in this plan during 1997. Other than as described herein or as identified in Tables I, II and III, the Company has no other long-term incentive plans for its executive officers.
<TABLE> TABLE I NATIONAL HEALTHCARE CORPORATION SUMMARY COMPENSATION TABLE 1998-1996 <CAPTION> Long Term Compensation ------------------------------------- Annual Compensation<F1> Awards Payouts - ---------------------------------------------------------- -------------------------------------- ---- (a) (b) (c) (d) (e) (f) (g) (h) (I) Other annual Restricted Options/ LTIP All Other Year Salary Bonus Compensation Stock Awards SARS Payouts Compen. Name and Principal ($) ($)<F4> ($)<F2> ($) (#)<F3> ($) ($) Position - ------------------ ---- ------ -------- ------------ ------------ -------- ------- --------- <S> <C> <C> <C> <C> <C> <C> <C> <C> W. Andrew Adams President & CEO 1998 109,478 <F5> 4,714 -0- -0- -0- -0- 1997 126,806 1,786,842 26,115 -0- -0- -0- -0- 1996 129,757 1,850,026 8,147 -0- -0- -0- -0- Robert G. Adams 1998 140,779 <F5> 9,889 -0- -0- -0- -0- Senior VP & COO 1997 140,553 882,626 3,817 -0- -0- -0- -0- 1996 140,279 1,238,857 8,269 -0- -0- -0- -0- Richard F. LaRoche, Jr. 1998 126,588 <F5> 18,034 -0- -0- -0- -0- Sr. VP & Secretary 1997 135,159 1,086,355 14,904 -0- -0- -0- -0- 1996 135,784 1,012,096 18,823 -0- -0- -0- -0- <FN> <F1> Compensation deferred at the election of an executive has been included in salary columns (c) and (d). <F2> Includes (a) life insurance benefit, (b) 401-K matching contribution, (c) nonqualified deferred compensation matching contribution, (d) ESOP contribution. <F3> These officers also received stock options from National Health Investors, Inc. in 1993, 1995, and 1997 which are disclosed in that Company's Form 10-K. No other Restricted Stock Awards, Options/SARs, or LTIP Payouts were given in 1996, 1997, or 1998. <F4> These officers also received bonuses from National Health Investors, Inc. and National Health Realty, Inc. which are disclosed in those Company's Form 10-K or proxy statements. <F5> No bonus has been declared or paid for 1998. </TABLE>
<TABLE> TABLE II NATIONAL HEALTHCARE CORPORATION OPTION/SAR GRANTS IN LAST FISCAL YEAR December 31, 1998 <CAPTION> Potential Realizable Value at Assumed Annual Rates of Unit Price Ap- presciation for Option Term <F2> - ------------------------------------------------------------------------------------------- (a) (b) (c) (d) (e) (f) (g) % of Total Options/SARs Granted to Exercise Options/SARs Employees in or Base Expiration Executive Officers Granted(#)<F1> Fiscal Year Price($/Sh) Date 5%($) 10%($) - ------------------ ------------- ------------ ----------- ---------- ----- ----- <S> <C> <C> <C> <C> <C> <C> W. Andrew Adams President & CEO -0- -0- -0- -0- -0- -0- Robert G. Adams Senior VP -0- -0- -0- -0- -0- -0- Richard F. LaRoche, Jr. Senior VP -0- -0- -0- -0- -0- -0- <FN> <F1> No options were awarded during 1998 to Executive Officers. <F2> Based on remaining option term (if any) and annual compounding. </TABLE>
<TABLE> TABLE III NATIONAL HEALTHCARE CORPORATION AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION/SAR VALUES December 31, 1998 <CAPTION> Number of Unexer- Value of Unexercised cised Options/ In-the-Money Options/ SARs at FY-End(#) SARs at FY-End($) ----------------- ------------------ Shares acquired Value Exercisable/ Exercisable/ Executive Officers on Exercise (#) Realized($)<F1> Unexercisable Unexercisable - ----------------------- --------------- --------------- ------------- ------------- <S> <C> <C> <C> <C> W. Andrew Adams President & CEO -0- -0- -0- -0- Robert G. Adams Senior VP -0- -0- -0- -0- Richard F. LaRoche, Jr. Senior VP -0- -0- -0- -0- <F1> Market value of underlying securities at exercise date, minus the exercise or base price. </TABLE>
Employee Stock Ownership Plan: In 1986 National Health Corporation ("National"), the former partnership's Administrative General Partner adopted as its Employee Stock Ownership Plan and Trust ("ESOP") the ESOP previously sponsored by the Company's corporate predecessor. The ESOP is a qualified pension plan under Section 401(a) of the Internal Revenue Code. National makes contributions to the ESOP for all employees and is reimbursed for same by the Company. Employees make no contributions. All contributions are used by the ESOP to purchase "qualifying employer securities" which is the Common Stock of National. These securities are allocated among National's employees who participate in the ESOP in the ratio of the employee's wages to the total wages of all participating employees during that fiscal year. Participating employees are all employees, including officers, who have earned one year of service by working more than 1,000 hours during the fiscal year. On January 20, 1988, National formed a Leveraged Employee Stock Purchase Plan (Leveraged ESOP). During 1988, the Leveraged ESOP borrowed, in two separate transactions, $88.5 million from four commercial banks, the proceeds of which were used to purchase additional stock from National. National, in turn, purchased eight (8) health care centers from the Company and contracted with the Company to manage these centers for a 20-year period. National also loaned $8.5 million to City Center, Ltd. to construct a 15-story office building in Murfreesboro, Tennessee, approximately 67% of which is occupied by the Company. In late 1988, National entered into a Loan Agreement with the Company and advanced $50,000,000 to the Company to be used by the Company to pay off its existing $30,000,000 revolving line of credit, with the balance to be used for acquisition, development and general working capital needs. In September of 1988, the original ESOP was merged into the Leveraged ESOP so that as of December 31, 1998, the employees still participated in only one qualified plan. On December 28, 1990, the Leveraged ESOP borrowed $50,000,000 from three commercial lenders, the proceeds of which were used as an equity contribution to National, which in turn loaned said proceeds to the Company at 8.48% fixed rate of interest. The proceeds were used for acquisition and new construction. The Leveraged ESOP is administered by an Administrative Committee, currently consisting of Ernest G. Burgess, III (Director), Donald K. Daniel and Charlotte Swafford (officers of the Company), which is appointed by National's Board of Directors. The Trustees of the Leveraged ESOP are Dr. Olin O. Williams, a director, and Richard F. LaRoche, Jr., the Company's Senior Vice President and General Counsel. The amounts contributed to the ESOP in 1998 and allocated to the Company's executive officers are included in Table I, and total $12,475. Employee Stock Purchase Plan: The Company has established its Employee Stock Purchase Plan for employees. Pursuant to the Plan, eligible employees may purchase Company common stock through payroll deductions at the lesser of the closing asked price of the common stock as reported on the American Stock Exchange on the first trading or the last trading day of each year. At the end of each year, funds accumulated in the employee's account will be used to purchase the maximum number of shares at the above price. The Company makes no contribution to the purchase price. 61,600 shares were issued pursuant to the Plan in January, 1999, with all payroll deductions being made in 1998.
All employees (including officers and directors) may elect to participate in the Plan if they meet minimum employment requirements. The maximum payroll deduction is the employee's normal monthly pay. Participating employee's rights under the plan are nontransferable. Prior to the end of a year, a participant may elect to withdraw from the Plan and the amount accumulated as a result of his payroll deductions shall be returned to him without interest. Any terminated employee immediately ceases to be a participant and also receives his or her prior contributions. In no event may a participant in the Plan purchase thereunder during a calendar year, common stock having a fair market value more than $25,000. The stock purchased pursuant to the Plan are freely tradeable, except for any shares held by an "affiliate" of the Company, which would be subject to the limitations of Rule 144. Only Mr. LaRoche and Mr. Robert Adams of the Company's executive officers participated in this Plan during 1998 and if there had been a positive spread between the purchase price and the then fair market price for these individuals it would have been included in Table I. 1975 Performance Bonus Plan: In 1975, the Company implemented a Performance Bonus Plan which was reaffirmed and readopted by the shareholders in 1994. This plan provides for the Chairman of the Board to allocate, with the approval of the non-employee directors, the bonus at the end of each fiscal year. The total amount available for bonuses under the plan is 20% of the Company's net income (without regard to NHI lease payments or Advisory fee income) after a 20% return on partners' equity as determined at the beginning of that fiscal year. 401(K) Plan: The Company and its affiliates offer a 401(K) Plan for all employees who are over 18 years of age. The Board of Directors has authorized a matching contribution to be made for 50% of contributions with contributions being matched up to 2.5% of quarterly gross wages. No employee may contribute more than 15% of wages to the Plan, and employees who earn more than $66,000 were limited to a contribution of no more than $3,500. These matching funds will be used to purchase Company stock on the open market, which shares will vest in the employees account only after the employee has achieved five years of vesting service. A total of $1,471,655 was contributed to the Plan as matching contributions for 1998.
Employee Loan and Bonus Programs: The Company has for many years participated in an Employee Stock Financing Plan (the "Financing Plan"). The Plan was designed to enable key employees of the Company to finance the exercise of stock options granted to them by the Board of Directors and only if authorized by the Board. Under the Plan, the Company may (but is not required)finance the exercise of any stock options by the acceptance of the employees' full recourse promissory note bearing interest at a fixed rate equal to 2.5% below New York prime on the date of the note, with interest payable quarterly and principal due and payable on ninety days notice, but no longer than 60 months. The notes are secured by company common stock having a fair market value equal to twice the note amount. The following tables show, as to each executive officer whose indebtedness exceeded $60,000, the largest aggregate amount of such indebtedness since December 31, 1996 and the present outstanding balance. <TABLE> <CAPTION> Financing Plan Largest Balance out- Aggregate standing as of Indebtedness 12/31/98 <S> <C> <C> <C> W. Andrew Adams Pres. & CEO $ 4,101,131 $1,641,920 Robert G. Adams Sr. VP & Dir. 2,426,309 1,206,950 Richard F. LaRoche, Jr. Sr. VP & Sec. 2,418,076 1,181,200 Ernest G. Burgess Director 1,309,368 802,030 J. K. Twilla Director 169,750 --- Lawrence C. Tucker Director --- --- Olin O. Williams Director 679,462 369,000 All Executive Officers ---------- --------- & Directors as a Group (7) $11,104,096 $5,201,100 </TABLE> Obligations to repay the Financing Plan loans are an asset of the Company, but are not reflected as increasing shareholder equity until paid. ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth certain information as to the number of shares of the Company beneficially owned as of December 31, 1998 (a) by each person (including any "group" as that term is used in Section 13(d)(3) of the Exchange Act) who is known to the Company to own beneficially 5% or more of the outstanding shares (11,316,898 as of December 31, 1998), (b) by each director, and (c) by all executive officers and directors of the Company as a group. Members of management of the Company listed below are all members of management and/or the Board of Directors, but they disclaim that they are acting as a "group" and the table below is not reflective of them acting as a group:
<TABLE> <CAPTION> Names and Addresses Number of Units<F1> Percentage of of Beneficial Owner Beneficially Owned Total Units <S> <C> <C> W. Andrew Adams, President & Chief Executive Officer 1,067,064 9.40% 801 Mooreland Lane Murfreesboro, TN 37128 Dr. J.K. Twilla, Director 83,392 .87% 525 Golf Club Lane Smithville, TN 37166 Dr. Olin O. Williams, Director 109,645 1.15% 2007 Riverview Drive Murfreesboro, TN 37129 Robert G. Adams, Director, Sr. V.P. 440,592 4.52% and Chief Operating Officer 2217 Tomahawk Trace Murfreesboro, TN 37129 Ernest G. Burgess, Director 189,320 1.98% 2239 Shannon Drive Murfreesboro, TN 37129 Richard F. LaRoche, Jr., Sr. V.P. 377,440 3.30% 2103 Shannon Drive Murfreesboro, TN 37130 National Health Corporation 1,238,924 10.90% P.O. Box 1398 Murfreesboro, TN 37133 Lawrence C. Tucker, Director 700,155<F2> 6.20% 1818 Fund, II 59 Wall Street New York NY 10005 Nicholas Fund, Inc. and 1,688,184 14.90% Albert O. Nichols 700 North Water Street Milwaukee, WI 53202 All Executive Officers, Directors 2,967,608 26.20% as a Group <FN> <F1> Assumes exercise of stock options and convertible subordinated debentures outstanding. See "Option Plans". <F2> Mr. Tucker, as a general partner of the 1818 Fund II, is attributed the ownership of the 1818 Fund II shares, but does not claim beneficial ownership thereof. Otherwise, all shares are owned beneficially with sole voting and investment power. Included in the amounts above are 15,000 shares to Mr. Burgess, 10,000 shares to Mr. Tucker, 200,000 shares to Dr. Twilla, and 15,000 shares to Dr. Williams, of which all may be acquired upon exercise of stock options granted under the Company's 1994 Stock Option Plan and 1997 Stock Option Plan. </TABLE>
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Certain Transactions National Health Corporation ("National") In January, 1988, NHC sold the assets of eight health care centers (1,121 licensed beds) to National for a total consideration of $40,000,000. The consideration consisted of $30,000,000 in cash and a $10,000,000 note receivable due December 31, 2007. The note receivable earns interest at 8.5% per annum. NHC has agreed to manage the centers under a 20-year management contract for management fees comparable to those in the industry. NHC has a receivable from National for management fees of approximately $3.3 million at December 31, 1998. As of December 31, 1998, National had borrowed $2,062,000 from NHC to finance the construction of additions at two health care centers. These notes are unsecured, mature in 2008 and require monthly principal and interest payments, with interest at the prime rate. In January, 1988, NHC obtained long-term financing of $8.5 million from National for its new headquarters building. The note requires quarterly principal and interest payments with interest at 9%. At December 31, 1998, the outstanding balance was approximately $4.6 million. The building is owned by a separate partnership of which NHC is the general partner and the other building tenants are limited partners. NHC has guaranteed the debt service of the building partnership. In addition, NHC's bank credit facility and the senior secured notes were financed through National and National's ESOP. NHC's interest costs, financing expenses and principal payments are equal to those incurred by National. In October 1991, NHC borrowed $10.0 million from National. This term note requires quarterly interest payments at 8.5% with the entire principal due at maturity in 2008. Contemporaneous with the merger of National HealthCare L.P. into NHC, the Company and National have entered into an Employee Services Agreement (the "Services Agreement") whereby NHC leases all of its employees from National. Pursuant to the Service Agreement, NHC will reimburse National for the gross payroll of employees provided to the Company plus a monthly fee equal to two percent of such month's gross payroll, but in no event shall such fee be less than the actual cost of administering the payroll and personnel department. The Services Agreement may be terminated by either at anytime with or without notice. National will be responsible for: the employment of all persons necessary to conduct the business of the Corporation and set all wages and salaries; the provision of all fringe benefits; the utilization of any qualified leveraged employee stock ownership plan; the payment of pensions, and establishment or continue and carry out pension, profit sharing, bonus, purchase, option, savings, thrift and other incentive and employee benefit plans; the purchase and payment of insurance; the indemnification and purchase of insurance on behalf of any fiduciary of any employee benefit plans and health insurance on behalf of any fiduciary of such plans. In the Services Agreement, the Company agrees to indemnify, defend and hold harmless National from any damages caused by a misrepresentation by the Company, litigation arising from the acts or failure to act of the Company or its agents in accordance with law or the Services Agreement, any employment
matters relating to the employees as a result of gross negligence or intentional misconduct by the Company or the failure of the Company to obtain and/or follow specific advice and direction from National in matters of employee separation and/or discipline. In addition, National agrees to indemnify and defend and hold harmless the Company from any damages caused by reason of or resulting from or relating to employee separation and/or discipline of National employees. PART IV ------- ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a) (I) Financial Statements: The Financial Statements are included as Exhibit 13 and are filed as part of this report. (ii) Exhibits: Reference is made to the Exhibit Index, which is found on page 46 of this Form 10-K Annual Report. b) Reports on Form 8-K: Filed October 30, 1998. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statement on Form S-8 File No. 33-9881 (filed December 28, 1987): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To National HealthCare Corporation: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements of National HealthCare Corporation (formerly National HealthCare L.P.) included in Item 14 of this Form 10-K, and have issued our report thereon dated February 3, 1999. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The financial statement schedule included in Item 14 is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not otherwise a required part of the basic consolidated financial statements. The financial statement schedule has been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements, and in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN LLP Nashville, Tennessee February 3, 1999
<TABLE> NATIONAL HEALTHCARE CORPORATION SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996 (in thousands) <CAPTION> Column A Column B Column C Column D Column E Additions Balance- Charged to Charged Balance Beginning Costs and to other -End of Description of Period Expenses Accounts Deductions<F1> Period - ----------- --------- --------- -------- ------------- ------ <S> <C> <C> <C> <C> <C> For the year ended December 31, 1996 - Allowance for doubtful accounts $4,441 $1,654 $ --- $1,356 $4,739 For the year ended December 31, 1997 - Allowance for doubtful accounts $4,739 $1,688 $ --- $ 949 $5,478 For the year ended December 31, 1998 - Allowance for doubtful accounts $5,478 $4,619 $ --- $2,137 $7,960 __________ <FN> <F1> Amounts written off, net of recoveries. </TABLE>
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. NATIONAL HEALTHCARE CORPORATION BY:/s/ Richard F. LaRoche, Jr. Richard F. LaRoche, Jr. Secretary Date: March 23, 1999 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 25, 1998, by the following persons on behalf of the registrant in the capacities indicated. Each director of the registrant whose signature appears below hereby appoints W. Andrew Adams and Richard F. LaRoche, Jr., and each of them severally, as his Attorney in Fact to sign in his name on his behalf as a director of the registrant and to file with the Commission any and all amendments of this report on Form 10-K. /s/ W. Andrew Adams /s/ Olin O. Williams W. Andrew Adams, President Olin O. Williams, M.D., Director Executive and Financial Officer /s/ Robert G. Adams /s/ J. K. Twilla Robert G. Adams, Senior Vice J.K. Twilla, M.D., Director President, Director /s/ Ernest G. Burgess /s/ Donald K. Daniel Ernest G. Burgess, Director Donald K. Daniel, Vice President and Principal Accounting Officer /s/ Lawrence C. Tucker Lawrence C. Tucker, Director
NATIONAL HEALTHCARE CORPORATION AND SUBSIDIARIES FORM 10-K FOR THE FISCAL YEAR ENDING DECEMBER 31, 1998 EXHIBIT INDEX Exhibit No. Description Page No. or Location - ------- ----------- -------------------- 3.1 Charter Specifically incorporated by reference to Exhibit A attached to Form S-4, (Proxy Statement-Prospectus), amended, Registration No. 333-37185, (December 5, 1997) 3.2 By-laws Specifically incorporated by reference to Exhibit A attached to Form S-4, (Proxy Statement-Prospectus), amended, Registration No. 333-37185, (December 5, 1997) 4.1 Form of Common Stock Specifically incorporated by reference to Exhibit A attached to Form S-4, (Proxy Statement-Prospectus), amended, Registration No. 333-37185, (December 5, 1997) 10 Material Contracts Incorporated by reference from Exhibits 10.1 thru 10.9 attached to Form S-4, (Proxy Statement- Prospectus), as amended, Registration No. 333-37185 (December 5, 1997) 10.11 Employee Stock Purchase Plan Specifically incorporated by reference to Exhibit A attached to Form S-4, )Proxy Statement-Prospectus), amended, Registration No. 333-37185, (December 5, 1997) 10.12 1997 Stock Option Plan Incorporated by reference from 1997 Proxy Statement/ Prospectus filed on December 5, 1997 12 Statements Re: Computation of Ratios Page 57 13 Report of Independent Public Accountants Exhibit 13 beginning Consolidated Statements of Income on Page 58 Consolidated Balance Sheets Consolidated Statements of Cash Flows Consolidated Statements of Partners' Capital Notes to Consolidated Financial Statements
22 Subsidiaries of Registrant Specifically incorporated by reference to Exhibit A attached to Form S-4, (Proxy Statement-Prospectus), amended, Registration No. 333-37185, (December 5, 1997) 23 Consent of Independent Page 85 Public Accountants 27 Financial Data Schedule (for SEC purposes only)
<TABLE> EXHIBIT 12 STATEMENT RE: COMPUTATION OF RATIOS AS REQUIRED BY ITEM 601(b)(12) OF REGULATION S-K NATIONAL HEALTHCARE CORPORATION <CAPTION> December 31 1998 1997 1996 1995 1994 <S> <C> <C> <C> <C> <C> Current Assets $119,811 $125,293 $ 80,094 $ 89,440 $ 97,506 Current Liabilities $ 92,784 $ 80,795 $ 72,803 $ 59,047 $ 55,038 Current Ratio 1.29 1.55 1.10 1.51 1.78 Long-Term Debt and Debt Serviced by Other Parties $ 72,202 $ 76,903 $157,535 $141,642 $194,007 Equity $ 50,315 $ 37,736 $128,537 $108,899 $101,006 Long-Term Debt and Debt Serviced by Other Parties to Equity 1.43 2.04 1.23 1.30 1.92 Net Income (Loss) $ (6,399) $ 37,008 $ 29,286 $ 21,115 $ 15,853 Average Equity $ 44,026 $159,457 $118,718 $104,953 $ 96,766 Return on Average Equity (14.6%) 23.2% 24.7% 20.1% 16.4% Total Liabilities $177,575 $183,627 $260,037 $231,501 $279,847 Partners' Capital and Deferred Income $ 72,113 $ 55,434 $144,703 $123,990 $116,286 Total Liabilities to Partners' Capital/Share- owners' Equity and and Deferred Income 2.46 3.31 1.8 1.9 2.4 </TABLE>
EXHIBIT 13 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Report of Independent Public Accountants 59 Consolidated Statements of Income 60 Consolidated Balance Sheets 61-62 Consolidated Statements of Cash Flows 63-64 Consolidated Statements of Shareowners' Equity and Partners' Capital 65 Notes to Consolidated Financial Statements 66-84
To National HealthCare Corporation: We have audited the accompanying consolidated balance sheets of National HealthCare Corporation (a Delaware corporation and formerly National HealthCare L.P.) and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, shareowners' equity and partners' capital, and cash flows for the years ended December 31, 1998, 1997 and 1996. These consolidated financial statements are the responsibility of National HealthCare Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of National HealthCare Corporation and subsidiaries as of December 31, 1998 and 1997, and the results of its operations and its cash flows for the years ended December 31, 1998, 1997 and 1996 in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP Nashville, Tennessee February 3, 1999
<TABLE> NATIONAL HEALTHCARE CORPORATION Consolidated Statements of Income (in thousands, except share and unit amounts) <CAPTION> Year Ended December 31 1998 1997 1996 <S> <C> <C> <C> Revenues: Net patient revenues $ 404,259 $ 410,963 $ 341,818 Other revenues 36,955 52,514 44,448 Net revenues 441,214 463,477 386,266 Costs and Expenses: Salaries, wages and benefits 243,348 258,325 209,645 Other operating 117,627 111,707 98,195 Litigation settlement and other charges 28,084 --- --- Rent 46,052 26,396 24,753 Depreciation and amortization 11,786 16,819 13,634 Interest 4,401 13,013 10,753 Total costs and expenses 451,298 426,260 356,980 Income (Loss) Before Income Taxes (10,084) 37,217 29,286 Income Tax Provision (Benefit) (3,685) 209 --- Net Income (Loss) $ (6,399) $ 37,008 $ 29,286 Earnings (Loss) Per Share/Unit: Basic $ (.58) $ 4.17 $ 3.48 Diluted (.58) 3.58 2.97 Weighted Average Shares/Units Outstanding: Basic 11,117,402 8,874,627 8,421,523 Diluted 11,117,402 10,838,567 10,496,407 </TABLE> The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.
<TABLE> NATIONAL HEALTHCARE CORPORATION Consolidated Balance Sheets (in thousands, except share amounts) <CAPTION> December 31 1998 1997 ---- ---- <S> <C> <C> Assets Current Assets: Cash and cash equivalents $ 12,630 $ 17,205 Cash held by trustees 3,871 3,834 Marketable securities 23,207 19,579 Accounts receivable, less allowance for doubtful accounts of $7,960 and $5,478, respectively 54,197 71,564 Notes receivable 18,182 6,992 Inventory, at lower of cost (first-in, first-out method) or market 4,207 3,948 Deferred income taxes 2,644 1,618 Prepaid expenses and other assets 873 553 Total current assets 119,811 125,293 Property, Equipment and Assets Under Arrangement With Other Parties: Property and equipment, at cost 136,247 113,477 Accumulated depreciation and amortization (50,498) (41,171) Assets under arrangement with other parties, net 4,120 4,853 Net property, equipment and assets under arrangement with other parties 89,869 77,159 Other Assets: Bond reserve funds, mortgage replacement reserves and other deposits 668 506 Unamortized financing costs, net 777 1,278 Notes receivable 5,999 11,044 Notes receivable from National 12,078 12,028 Deferred income taxes 12,374 2,922 Minority equity investments and other 8,112 8,831 Total other assets 40,008 36,609 Total assets $249,688 $239,061 </TABLE> The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.
<TABLE> NATIONAL HEALTHCARE CORPORATION Consolidated Balance Sheets (in thousands, except share amounts) <CAPTION> December 31 1998 1997 <S> <C> <C> Liabilities and Shareowners' Equity Current Liabilities: Current portion of long-term debt $ 3,779 $ 2,682 Trade accounts payable 16,317 12,810 Accrued payroll 23,846 38,123 Distributions payable --- 5,388 Amount due to third party payors 33,599 6,789 Accrued interest 235 596 Other current liabilities 14,965 14,407 Total current liabilities 92,741 80,795 Long-Term Debt, Less Current Portion 56,311 60,227 Debt Serviced by Other Parties, Less Current Portion 15,891 16,676 Other Noncurrent Liabilities 11,248 6,014 Minority Interests in Consolidated Subsidiaries 670 763 Subordinated Convertible Notes 714 19,152 Deferred Income 21,798 17,698 Commitments, Contingencies and Guarantees Shareowners' Equity: Preferred stock, $.01 par value; 10,000,000 shares authorized; none issued or outstanding --- --- Common stock, $.01 par value; 30,000,000 shares authorized; 11,378,558 and 10,103,172 shares, respectively, issued and outstanding 114 101 Capital in excess of par value, less notes receivable 52,838 33,248 Retained earnings (6,399) -- Unrealized gains on marketable securities 3,762 4,387 Total shareowners' equity 50,315 37,736 Total liabilities and shareowners' equity $249,688 $239,061 </TABLE> The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.
<TABLE> NATIONAL HEALTHCARE CORPORATION Consolidated Statements of Cash Flows (in thousands) <CAPTION> Year Ended December 31 1998 1997 1996 ---- ---- ---- <S> <C> <C> <C> Cash Flows From Operating Activities: Net income (loss) $ (6,399) $ 37,008 $ 29,286 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation 11,328 15,665 12,453 Provision for doubtful accounts receivable 3,642 1,688 1,654 Amortization of intangibles and deferred charges1,232 598 1,083 Amortization of deferred income (413) (1,334) (295) Equity in earnings of unconsolidated investments (197) (201) (313) Distributions from unconsolidated investments and other 157 160 210 Deferred income taxes (10,478) (4,540) --- Changes in assets and liabilities: (Increase) decrease in accounts receivable 4,127 (22,350) (5,271) Increase in inventory (259) (376) (497) (Increase) decrease in prepaid expenses and other assets (320) 389 (89) Increase in trade accounts payable 3,507 975 5,693 Increase (decrease) in accrued payroll (14,277) 9,160 5,087 Increase (decrease) in amounts due to third party payors 26,810 (6,346) 3,335 Increase (decrease) in accrued interest (272) 116 (1,321) Increase in other liabilities 5,792 10,626 946 Increase in entrance fee deposits 4,513 --- --- Net cash provided by operating activities 28,493 41,238 51,961 Cash Flows From Investing Activities: Additions to and acquisitions of property and equipment, net (24,038) (43,707) (69,970) Investments in notes receivable (31,639) (38,436) (20,170) Collections of notes receivable 35,042 23,807 38,862 (Increase) decrease in minority equity investments and other 18 (2,827) (441) (Increase) decrease in marketable securities, net (4,253) 605 (14,628) Sales of investments --- --- 1,900 Net cash used in investing activities (24,870) (60,558) (64,447) Cash Flows From Financing Activities: Proceeds from debt issuance 922 45,319 29,183 Proceeds from issuance of subordinated convertible notes --- 20,000 --- Increase in cash held by trustees (37) (1,560) (553) Decrease in minority interests in consolidated subsidiaries (93) (28) (21) Issuance of common shares/partnership units 1,018 2,344 1,378 Collections of receivables from exercise of options 68 17,375 3,522 (Increase) decrease in bond reserve funds, mortgage replacement reserves and other deposits (162) (365) 1,648 Payments on debt (4,526) (27,141) (8,138) Cash distributions to partners (5,388) (21,021) (17,466) Increase in financing costs --- (279) (21) Net cash provided by (used in) financing activities (8,198) 34,644 9,532 Net Increase (Decrease) In Cash and Cash Equivalents (4,575) 15,324 (2,954) Cash and Cash Equivalents, Beginning of Period 17,205 1,881 4,835 Cash and Cash Equivalents, End of Period $ 12,630 $ 17,205 $ 1,881 </TABLE>
<TABLE> <CAPTION> Year Ended December 31 1998 1997 1996 (in thousands, except share and unit amounts) <S> <C> <C> <C> Supplemental Information: Cash payments for interest expense $ 4,673 $ 12,918 $ 12,074 During 1998, 1997 and 1996, $18,438, $29,756 and $1,092, respectively, of subordinated con- vertible notes were converted into 1,212,504, 1,197,119 and 71,810 of NHC's partnership units and common stock Subordinated convertible notes $(18,438) $(29,756)$ (1,092) Financing costs 10 131 --- Accrued interest (89) 320 --- Common stock 12 --- --- Partners' capital and shareowners' equity 18,505 29,305 1,092 During 1998, NHC invested in a note receivable in exchange for NHC's rights to accounts receivable Accounts receivable $ 9,598 $ --- $ --- Notes receivable (9,598) --- --- During 1997 and 1996, NHC was released from its liability on debt serviced by other parties by the respective lenders Debt serviced by other parties $ --- $(15,569)$ (5,136) Assets under arrangement with other parties --- 15,569 5,136 At December 31, 1997, NHC transferred certain assets, related liabilities and equity to National Health Realty, Inc., a real estate investment trust Net book value of assets transferred $ --- $239,054 $ --- Mortgage notes payable transferred --- (86,414) --- Equity transferred --- (152,640) --- </TABLE> The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.
<TABLE> NATIONAL HEALTHCARE CORPORATION Consolidated Statements of Shareowners' Equity and Partners' Capital (in thousands, except share and unit amounts) <CAPTION> Unrealized Total Share- Receivables Capital in Gains owners' Equity Common Stock/Units from Sale Excess of Retained (Losses) on General Limited and Partners' Shares/Units Amount of Units Par Value Earnings Securities Partners Partners Capital ------------ ------ ----------- --------- -------- ----------- -------- -------- ------------ <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> Balance at 12/31/95 8,353,114 $ --- $(26,196) $ --- $ --- $ 345 $ 1,290 $133,460 $108,899 Net income --- --- --- --- --- --- 293 28,993 29,286 Unrealized gains on securities --- --- --- --- --- 1,826 --- --- 1,826 Total comprehensive income 31,112 Collection of receivables --- --- 3,522 --- --- --- --- --- 3,522 Units sold 43,035 --- --- --- --- --- --- 1,378 1,378 Units issued in conversion of convertible notes to partnership units 71,810 --- --- --- --- --- --- 1,092 1,092 Cash distributions declared ($2.08 per unit) --- --- --- --- --- --- (175) (17,291) (17,466) Balance at 12/31/96 8,467,959 --- (22,674) --- --- 2,171 1,408 147,632 128,537 Net income --- --- --- --- --- --- 370 36,638 37,008 Unrealized gains on securities --- --- --- --- --- 2,216 --- --- 2,216 Total comprehensive income 39,224 Collection of receivables --- --- 17,375 --- --- --- --- --- 17,375 Units sold 438,094 --- (11,576) --- --- --- --- 13,920 2,344 Units issued in conversion of convertible notes to part- nership units 1,197,119 --- --- --- --- --- --- 29,305 29,305 Equity transferred to National Health Realty, Inc. --- --- --- --- --- --- (1,514) (151,126) (152,640) Cash distributions declared ($3.00 per unit) --- --- --- --- --- --- (264) (26,145) (26,409) 10,103,172 --- (16,875) --- --- 4,387 --- 50,224 37,736 Effect of reorganization from limited partnership to corporation --- 101 --- 50,123 --- --- --- (50,224) --- Balance at 12/31/97 10,103,172 101 (16,875) 50,123 --- 4,387 --- --- 37,736 Net loss --- --- --- --- (6,399) --- --- --- (6,399) Unrealized losses on securities (net of tax of $418) --- --- --- --- --- (625) --- --- (625) Total comprehensive loss (7,024) Collection of receivables --- --- 68 --- --- --- --- --- 68 Shares sold 62,882 1 --- 1,017 --- --- --- --- 1,018 Shares issued in conversion of convertible notes to common shares 1,212,504 12 --- 18,505 --- --- --- --- 18,517 Balance at 12/31/98 11,378,558 $ 114 $(16,807 ) $69,645 $ (6,399) $3,762 $ --- $ --- $ 50,315 </TABLE> The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.
Notes to Consolidated Financial Statements Note 1 - Summary of Significant Accounting Policies: Presentation-- The consolidated financial statements include the accounts of National HealthCare Corporation and its subsidiaries ("NHC" or the "Company" and formerly National HealthCare L.P.). All material intercompany balances, profits, and transactions have been eliminated in consolidation, and minority interests are reflected in consolidation. Investments in entities in which NHC lacks control but has the ability to exercise significant influence over operating and financial policies are accounted for on the equity method. Investments in entities in which NHC lacks the ability to exercise significant influence are included in the consolidated financial statements at the cost of NHC's investment or, if applicable, at fair value. Certain reclassifications have been made to the 1996 and 1997 financial statements to conform to the 1998 presentation. 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. Health Care Revenues-- NHC's principal business is operating and managing long-term health care centers, including the provision of routine and ancillary services. Approximately 60% of NHC's net revenues in 1998, 56% in 1997 and 60% in 1996 are from participation in Medicare and Medicaid programs. Amounts paid under these programs are generally based on a facility's allowable costs or a fixed rate subject to program cost ceilings. Revenues are recorded at standard billing rates less allowances and discounts principally for patients covered by Medicare, Medicaid and other contractual programs. These allowances and discounts were $114,275,000, $99,273,000 and $110,795,000 for 1998, 1997 and 1996, respectively. Amounts earned under the Medicare, Medicaid and other governmental programs are subject to review by the third party payors. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. NHC generally expects final determinations to occur two to three years subsequent to the year in which amounts are earned. Any differences between estimated settlements and final determinations are reflected in operations in the year finalized. NHC has submitted various requests for exceptions to Medicare routine cost limitations for reimbursement. NHC has received approval on certain requests, and others are pending approval. NHC will record revenues associated with the approved requests when such approvals, including cost report audits, are assured. Provision for Doubtful Accounts-- Provisions for estimated uncollectible accounts and notes receivable are included in other operating expenses.
Property, Equipment and Assets Under Arrangement with Other Parties-- NHC uses the straight-line method of depreciation over the expected useful lives of property and equipment estimated as follows: buildings and improvements, 20-40 years; equipment and furniture, 3-15 years; and properties under arrangement with other parties, 10-20 years. The provision for depreciation includes the amortization of properties under capital leases and properties under arrangement with National Health Investors, Inc. ("NHI"). Expenditures for repairs and maintenance are charged against income as incurred. Betterments are capitalized. NHC removes the costs and related allowances from the accounts for properties sold or retired, and any resulting gains or losses are included in income. NHC includes interest costs incurred during construction periods in the cost of buildings ($1,344,000 in 1998 and $1,277,000 in 1997). In accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets To Be Disposed Of" ("SFAS 121"), NHC evaluates the recoverability of the carrying values of its properties on a property by property basis. Investments in Marketable Securities-- NHC considers its investments in marketable securities as available for sale securities and unrealized gains and losses are recorded in shareowners' equity in accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). Intangible Assets-- Any excess of cost over net assets of companies purchased is amortized generally over 20 years using the straight-line method. Deferred financing costs are amortized principally by the interest method over the terms of the related loans. Income Taxes-- During 1997 and 1996, NHC was a publicly traded limited partnership. Accordingly, NHC was not a taxable entity and the earnings of NHC were taxable to the individual partners. Effective December 31, 1997, NHC became a taxable corporate entity. In accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), effective December 31, 1997, NHC began recognizing deferred income taxes for the consequences of temporary differences by applying enacted statutory tax rates for differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Concentration of Credit Risks-- NHC's credit risks primarily relate to cash and cash equivalents, cash held by trustees, accounts receivable, marketable securities and notes receivable. Cash and cash equivalents are primarily held in bank accounts and overnight investments. Cash held by trustees is primarily invested in commercial paper and certificates of deposit with financial institutions.
Accounts receivable consist primarily of amounts due from patients (funded approximately 81% through Medicare, Medicaid, and other contractual programs and approximately 19% through private payors) in the states of Alabama, Florida, Georgia, Kentucky, Missouri, South Carolina, Tennessee, and Virginia and from other health care companies for management services. NHC performs continual credit evaluations of its clients and maintains allowances for doubtful accounts on these accounts receivable. Marketable securities are held primarily in accounts with brokerage institutions. Notes receivable relate primarily to secured loans with health care facilities and to secured notes receivable from officers, directors and supervisory employees as discussed in Notes 10 and 14. NHC also has notes receivable from National Health Corporation as discussed in Note 5. NHC's financial instruments, principally its notes receivable, are subject to the possibility of loss of the carrying values as a result of either the failure of other parties to perform according to their contractual obligations or changes in market prices which may make the instruments less valuable. NHC obtains various collateral and other protective rights, and continually monitors these rights, in order to reduce such possibilities of loss. NHC evaluates the need to provide for reserves for potential losses on its financial instruments based on management's periodic review of its portfolio on an instrument by instrument basis. See Notes 10 and 14 for additional information on the notes receivable. Cash and Cash Equivalents-- Cash equivalents include highly liquid investments with an original maturity of less than three months. New Accounting Pronouncements-- In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 requires that changes in the amounts of certain items, including gains and losses on marketable securities, be shown in the consolidated financial statements. NHC retroactively adopted the provisions of SFAS 130 effective January 1, 1998. NHC has elected to disclose comprehensive income, which includes net income and unrealized gains and losses on marketable securities, in the consolidated statements of shareowners' equity and partners' capital. In April 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 98-5 ("SOP 98-5") effective for fiscal years beginning after December 15, 1998. SOP 98-5 requires that all nongovernmental entities expense the costs of start-up activities as those costs are incurred. The statement also requires nongovernmental entities to write off any unamortized start-up costs that remain on the balance sheet at the date of adoption. NHC will adopt the provisions of SOP 98-5 effective January 1, 1999. Management does not expect the adoption to have a material impact on NHC's financial position, results of operations or cash flows.
Note 2 - Restructure from Limited Partnership to Corporation: Under the Revenue Act of 1987, NHC and certain other similar publicly traded partnerships were permitted to be taxed as partnerships and not as corporations through December 31, 1997. However, NHC became subject to federal income taxes for taxable income generated subsequent to December 31, 1997. In response to the governmentally mandated loss of partnership tax status, the holders of NHC general and limited partnership units approved a plan of restructure whereby, on December 31, 1997, NHC converted from a limited partnership to a corporation. All partnership units outstanding on December 31,1997 were effectively converted into shares of common stock. The restructure from a limited partnership to a corporation had no effect on the liquidity or financial condition of NHC. Note 3 - Relationship with National Health Realty, Inc.: Transfer of Assets-- On December 31, 1997, NHC transferred certain assets including mortgage notes receivable (total book value of $94,439,000), the real property of 16 long-term health care centers, six assisted living facilities and one retirement center (total book value of $144,615,000) and related liabilities (total book value of $86,414,000) to National Health Realty, Inc. ("NHR"), a publicly traded Maryland corporation qualified as a real estate investment trust ("REIT") under federal laws, and NHR/OP, L.P. (the "Operating Partnership"). NHR/OP, L.P. is a Delaware limited partnership which is the operating entity of NHR. In exchange for the assets transferred, NHC received 8,237,423 shares of common stock of NHR, which was all of the outstanding common stock of NHR. NHC distributed the common stock of NHR to NHC's unitholders at the rate of one share for each unit outstanding on the record date December 31, 1997. In order to protect the REIT status of NHR, certain NHC unitholders received 1,310,194 units of the Operating Partnership rather than NHR shares. NHR was incorporated on September 26, 1997 as a wholly-owned subsidiary of NHC for the purpose of consummating the transactions described herein. The distribution of NHR's common stock to NHC unitholders effectively separated NHC and NHR into two independent public companies, although the Boards of Directors are identical save for one additional member on NHC's Board. Leases-- Concurrent with NHC's conveyance of the real property to NHR, NHC leased from NHR each of the 23 facilities. Each lease is for an initial term expiring December 31, 2007, with two additional five year renewal terms at the option of NHC, assuming no defaults. NHC accounts for the leases as operating leases. During the initial term and each renewal term, NHC is obligated to pay NHR annual base rent on all 23 facilities of $15,485,000. In addition to base rent, in each year after 1999, NHC must pay percentage rent to NHR equal to 3% of the amount by which gross revenues of each facility in such later year exceed the gross revenues of such facility in 1999. Each lease with NHR is a "triple net lease" under which NHC is responsible for paying all taxes, utilities, insurance premium costs, repairs and other charges relating to the ownership of the facilities. NHC is obligated at its expense to maintain adequate insurance on the facilities' assets.
NHC has a right of first refusal with NHR to purchase any of the properties transferred from NHC should NHR receive an offer from an unrelated party during the term of the lease or up to 180 days after termination of the related lease. At December 31, 1998, the approximate future minimum base rent commitments to be paid by NHC on non-cancelable operating leases with NHR are as follows: 1999 $15,485,000 2000 15,485,000 2001 15,485,000 2002 15,485,000 2003 15,485,000 Thereafter 61,940,000 Advisory Agreement-- Effective December 31, 1997, NHC entered into an Advisory Agreement with NHR whereby services related to investment activities and day-to-day management and operations are provided to NHR by NHC as Advisor. The Advisor is subject to the supervision of and policies established by NHR's Board of Directors. Either party may terminate the Advisory Agreement on 90 days notice at any time after January 1, 2000. NHR may terminate the Advisory Agreement for cause at any time. For its services under the Advisory Agreement, NHC is entitled to annual compensation of the greater of 2% of NHR's gross consolidated revenues or the actual expenses incurred by NHC. During 1998, NHC's compensation under the Advisory Agreement was $471,000. Pursuant to the Advisory Agreement, NHR has agreed that as long as both the NHR Advisory Agreement and the NHI Advisory Agreement are obligations of NHC, NHR will only do business with NHC and will not compete with NHI. As a result, NHR is severely limited in its ability to grow and expand its business. Furthermore, NHC will not seek additional investments to expand NHR's investment portfolio. Tax Treatment of the Transfer-- The transfer of assets was treated as a nontaxable exchange under Section 351 of the Internal Revenue Code of 1986, as amended. For federal income tax purposes, no gain or loss was recognized by NHC or by its unitholders upon the transfer of assets to NHR or upon the distribution of the shares of NHR. The tax basis of shares of NHR received by NHC unitholders in the distribution was $16.54 per share before a number of special tax adjustments related to the price paid for NHC units and the length of time such units were held. The tax basis in each share of NHR could not exceed the overall basis in NHC units.
Pro Forma Results-- The unaudited pro forma results of NHC for the year ended December 31, 1997 are presented as if the transaction with NHR had occurred on January 1, 1997 and include the following adjustments: 1) Advisory fee income from NHR, 2) Changes in interest income and interest expense related to the transfer of mortgage notes receivable and debt to NHR, 3) Base rent expense related to real property transferred to NHR, and 4) Decrease in depreciation expense related to real property transferred to NHR. The unaudited pro forma results are as follows: (in thousands, except per unit amounts) (unaudited) Net revenues $454,647 Total costs and expenses 429,248 Net income $ 25,399 Earnings per unit Basic $ 2.86 Diluted $ 2.51 Note 4 - Relationship with National Health Investors, Inc.: Leases-- On October 17, 1991, concurrent with NHC's conveyance of real property to NHI, NHC leased from NHI the real property of 40 long-term care centers and three retirement centers. Each lease is for an initial term expiring December 31, 2001, with two additional five-year renewal terms at the option of NHC, assuming no defaults. NHC accounts for the leases as operating leases. During the initial term and first renewal term of the leases, NHC is obligated to pay NHI annual base rent on all 43 facilities of $15,238,000. If NHC exercises its option to extend the leases for the second renewal term, the base rent will be the then fair rental value as negotiated by NHC and NHI. The leases also obligate NHC to pay as debt service rent all payments of interest and principal due under each mortgage to which the conveyance of the facilities was subject. The payments are required over the remaining life of the mortgages as of the conveyance date, but only during the term of the lease. Payments for debt service rent are being treated by NHC as payments of principal and interest if NHC remains obligated on the debt ("obligated debt service rent") and as operating expense payments if NHC has been relieved of the debt obligation by the lender ("non-obligated debt service rent"). See "Accounting Treatment of the Transfer" for further discussion. In addition to base rent and debt service rent, in each year after 1992, NHC must pay percentage rent to NHI equal to 3% of the amount by which gross revenues of each facility in such later year exceed the gross revenues of such facility in 1992. Percentage rent for 1998 and 1997 was approximately $2,521,000 and $2,294,000, respectively.
Each lease with NHI is a "triple net lease" under which NHC is responsible for paying all taxes, utilities, insurance premium costs, repairs and other charges relating to the ownership of the facilities. NHC is obligated at its expense to maintain adequate insurance on the facilities' assets. NHC has a right of first refusal with NHI to purchase any of the properties transferred from NHC should NHI receive an offer from an unrelated party during the term of the lease or up to 180 days after termination of the related lease. Base rent expense to NHI was $15,238,000 in 1998, 1997 and 1996. Non- obligated debt service rent to NHI was $5,338,000 in 1998 and $5,430,000 in 1997. At December 31, 1998, the approximate future minimum base rent, non- obligated debt service rent, and obligated debt service rent commitments to be paid by NHC on non-cancelable operating leases with NHI during the initial term are as follows: 1999 $29,297,000 2000 29,290,000 2001 29,313,000 2002 --- 2003 --- Thereafter --- Advisory Agreement-- NHC has entered into an Advisory Agreement with NHI whereby services related to investment activities and day-to-day management and operations are provided to NHI by NHC as Advisor. The Advisor is subject to the supervision of and policies established by NHI's Board of Directors. Either party may terminate the Advisory Agreement on 90 days notice at any time. NHI may terminate the Advisory Agreement for cause at any time. For its services under the Advisory Agreement, NHC's annual compensation is calculated to be $3,310,000, $3,101,000, and $3,100,000 in 1998, 1997 and 1996, respectively. However, the payment of such annual compensation is conditional upon NHI having sufficient funds from operations to pay annual dividends of $2.00 per share and upon NHI paying such dividends. NHI met this condition in 1998, 1997 and 1996. Accounting Treatment of the Transfer-- NHC has accounted for the conveyance in 1991 of assets (and related debt) to NHI and the subsequent leasing of the real estate assets as a "financing/leasing" arrangement. Since NHC remains obligated on certain of the transferred debt, the obligated debt and applicable asset balances have been reflected on the consolidated balance sheets as "assets under arrangement with other parties" and "debt serviced by other parties". The net book value equity of the assets transferred has been transferred from NHC to NHI. As NHC utilizes the applicable real estate over the lease term, its consolidated statements of income will reflect the continued depreciation of the applicable assets over the lease term, the continued interest expenses on the obligated debt balances and the additional base and non-obligated debt service rents (as an operating expense) payable to NHI each year. NHC has recovery provisions from NHI if NHC is required to service the debt through a default by NHI.
Release from Debt Serviced by Other Parties-- In 1997 and 1996, NHI prepaid or NHC was released from its obligation on transferred debt in the amounts of $15,569,000 and $5,136,000, respectively. Since NHC is no longer obligated on this transferred debt, debt serviced by other parties and assets under arrangement with other parties were reduced by $15,569,000 and $5,136,000 in 1997 and 1996, respectively. The leases with NHI provide that NHC shall continue to make non-obligated debt service rent payments equal to the debt service including principal and interest on the obligated debt which was prepaid and from which NHC has been released. Note 5 - Relationship With National Health Corporation: Sale of Health Care Centers-- During 1988, NHC sold the assets (inventory, property and equipment) of eight health care centers (1,121 licensed beds) to National Health Corporation ("National"), the administrative general partner of NHC at the time of the sale, for a total consideration of $40,000,000. The consideration consisted of $30,000,000 in cash and a $10,000,000 note receivable due December 31, 2007. The note receivable earns interest at 8.5%. NHC has agreed to manage the centers under a 20-year management contract for management fees comparable to those in the industry. With the prior consent of NHC, National sold one center to an unrelated third party in 1997; thus, NHC now manages seven centers for National. NHC has a receivable from National for management fees of approximately $3,255,000 and $4,512,000 at December 31, 1998 and 1997, respectively. NHC's basis in the assets sold was approximately $24,255,000. The resulting profit of $15,745,000 was deferred and will be amortized into income beginning with the collection of the note receivable (up to $12,000,000) with the balance ($3,745,000) of the profit being amortized into income on a straight-line basis over the management contract period. As of December 31, 1998, National had borrowed $2,062,000 from NHC to finance the construction of additions at two health care centers. The notes require monthly principal and interest payments. The interest rate is equal to the prime rate, and the notes mature in 2008. Financing Activities-- During 1988, NHC obtained long-term financing of $8,500,000 for its new headquarters building from National through the National Health Corporation Leveraged Employee Stock Ownership Plan and Trust (the "ESOP"). The note requires quarterly principal and interest payments with interest at 9%. At December 31, 1998 and 1997, the outstanding balance on the note was approximately $4,581,000 and $5,078,000, respectively. The building is owned by a separate partnership of which NHC is the general partner and building tenants are limited partners. NHC has guaranteed the debt service of the building partnership. In addition, NHC's $13,273,000 bank credit facility and the $7,751,000 senior secured notes described in Note 11 were financed through National and the ESOP. NHC's interest costs, financing expenses and principal payments are equal to those incurred by National. During 1991, NHC borrowed $10,000,000 from National. The term note payable requires quarterly interest payments at 8.5%. The entire principal is due at maturity in 2008.
Payroll and Related Services-- The personnel conducting the business of NHC are employees of National, which provides payroll services, provides employee fringe benefits, and maintains certain liability insurance. NHC pays to National all the costs of personnel employed for the benefit of NHC, as well as an administrative fee ($2,121,000 in 1998) equal to 1% of payroll costs. National maintains and makes contributions to its ESOP for the benefit of eligible employees. Note 6 - Other Revenues: Revenues from management services include management fees, interest income on notes receivable, and revenues from other services provided to managed long-term care centers. "Other" revenues include non-health care related earnings. <TABLE> (in thousands) <CAPTION> Year Ended December 31 1998 1997 1996 ---- ---- ---- <S> <C> <C> <C> Revenues from managed services $24,522 $38,339 $32,363 Guarantee fees 581 628 693 Advisory fees from NHI and NHR 3,781 3,101 3,100 Dividends and other realized gains on securities 1,498 1,728 932 Equity in earnings of unconsolidated investments 197 201 313 Interest income 3,900 4,333 4,386 Other 2,476 4,184 2,661 ------ ------ ------ $36,955 $52,514 $44,448 </TABLE> Note 7 - Earnings Per Share/Unit: In 1997 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128"). NHC adopted the provisions of SFAS 128 during the fourth quarter of 1997 and has restated earnings per unit for 1996. Basic earnings per share/unit is based on the weighted average number of common shares/units outstanding during the year. Diluted earnings per share/unit assumes the conversion of the subordinated convertible notes and the exercise of options using the treasury stock method. Net income is increased for interest expense on the subordinated convertible notes. The calculation of diluted earnings per share/unit for 1998 excludes the effect of the subordinated convertible notes and options because treatment of the notes and options as if converted in a net loss period would have had an anti-dilutive effect. The following table summarizes the earnings and the average number of common shares/units used in the calculation of basic and diluted earnings per share/unit: (dollars in thousands, except per share/unit amounts)
<TABLE> <CAPTION> Year Ended December 31 1998 1997 1996 <S> <C> <C> <C> Basic: Weighted average common shares/units 11,117,402 8,874,627 8,421,523 Net income (loss) $ (6,399) $ 37,008 $ 29,286 Earnings (loss) per common share/unit, basic $ (.58) $ 4.17 $ 3.48 Diluted: Weighted average common shares/units 11,117,402 8,874,627 8,421,523 Options --- 5,565 148,685 Subordinated convertible notes --- 1,958,375 1,926,199 Assumed average common shares/units outstanding 11,117,402 10,838,567 10,496,407 Net income (loss) $ (6,399) $ 37,008 $ 29,286 Interest expense on subordinated convertible notes --- 1,809 1,850 Net income (loss) assuming con- version of subordinated con- vertible notes $ (6,399) $ 38,817 $ 31,136 Earnings (loss) per common share/unit, diluted $ (.58) $ 3.58 $ 2.97 </TABLE> Note 8 - Investments in Marketable Securities: NHC considers its investments in marketable securities as available for sale securities and unrealized gains and losses are recorded in shareowners' equity in accordance with SFAS 115. Marketable securities consist of the following: <TABLE> <CAPTION> (in thousands) December 31 1998 1997 ----------------- ----------------- Fair Fair Cost Value Cost Value ------- ------- ------- ------- <S> <C> <C> <C> <C> Marketable equity securities $15,300 $18,644 $15,192 $19,579 U.S. government securities 1,109 1,109 --- --- Corporate bonds 3,454 3,454 --- --- $19,863 $23,207 $15,192 $19,579 </TABLE> The amortized cost and estimated fair value of marketable securities classified as available for sale, by contractual maturity are as follows: <TABLE> <CAPTION> (in thousands) December 31 1998 1997 Fair Fair Cost Value Cost Value ------- ------- ------- ------- <S> <C> <C> <C> <C> Maturities: 1 to 5 years $ 3,689 $ 3,689 $ --- $ --- 6 to 10 years 874 874 --- --- Other securities without stated maturity 15,300 18,644 15,192 19,579 ------- ------- ------- ------- $19,863 $23,207 $15,192 $19,579 </TABLE>
Proceeds from the sale of investments in debt and equity securities during the years ended December 31, 1998 and 1997 were $220,000 and $854,000, respectively. Gross investment losses of $13,000 were realized on these sales during the year ended December 31, 1998. Gross investment gains of $249,000 were realized on these sales during the year ended December 31, 1997. Realized gains and losses from securities sales are determined on the specific identification of the securities. Note 9 - Property, Equipment and Assets Under Arrangement with Other Parties: Property and equipment, at cost, consist of the following: (in thousands) <TABLE> <CAPTION> December 31 1998 1997 -------- -------- <S> <C> <C> Land $ 9,697 $ 3,404 Buildings and improvements 43,437 38,173 Furniture and equipment 74,655 67,235 Construction in progress 8,458 4,665 -------- -------- $136,247 $113,477 </TABLE> Assets under arrangement with other parties, net of accumulated depreciation, consist of the following: <TABLE> <CAPTION> (in thousands) December 31 1998 1997 ------- -------- <S> <C> <C> Land $ 517 $ 556 Buildings and improvements 3,385 4,012 Fixed equipment 218 285 $ 4,120 $ 4,853 </TABLE> Note 10 - Notes Receivable: Notes receivable generally consist of loans and accrued interest to managed health care centers and retirement centers for construction costs, development costs incurred during construction and working capital during initial operating periods. The notes generally require monthly payments with maturities beginning in 1999 through 2003. Interest on the notes is generally at prime plus 2%. The collateral for the notes consists of first and second mortgages, certificates of need, personal guarantees and stock pledges. Note 11 - Long-Term Debt, Debt Serviced by Other Parties and Lease Commitments: Long-Term Debt and Debt Serviced by Other Parties-- Long-term debt and debt serviced by other parties consist of the following:
<TABLE> <CAPTION> Weighted Average Final Debt Serviced by Long-Term Interest Rate Maturities Other Parties Debt (in thousands) ---------------- ---------- ---------------- --------------- December 31 1998 1997 1998 1997 <S> <C> <C> <C> <C> <C> <C> Bank credit facility, interest payable periodically, principal variable, due at maturity 6.3% 2000 $ --- $ --- $ 20,000 $ 20,000 Bank credit facility, principal and interest payable variable, quarterly 5.6 2009 --- --- 13,273 14,085 Senior secured notes, principal and interest payable semi- annually 8.4 2005 --- --- 7,751 9,383 Notes and other obligations, principal and interest payable periodically 7.1 1999-2019 4,238 4,333 8,261 8,461 First mortgage revenue bonds, principal payable periodically, variable, interest payable monthly 5.3 2000-2010 12,458 13,323 --- --- Unsecured term note payable to National, interest payable quarterly, principal payable at maturity 8.5 2008 --- --- 10,000 10,000 16,696 17,656 59,285 61,929 Less current portion (805) (980) (2,974) (1,702) $15,891 $ 16,676 $ 56,311 $ 60,227 </TABLE>
The $13,273,000 bank credit facility and the $7,751,000 senior secured notes were borrowed through National. NHC granted certain credits and interest rate concessions related to its management fees from National in obtaining these loans. To obtain the consent of various lenders to the transfer of assets, NHI guaranteed certain NHC debt which was not transferred to NHI. A default by NHI under its obligations would default the debt or guarantees of NHC. The aggregate maturities of long-term debt and debt serviced by other parties for the five years subsequent to December 31, 1998 are as follows: <TABLE> <CAPTION> Long-Term Debt Serviced Debt By Other Parties Total ----------- ---------------- ----------- <S> <C> <C> <C> 1999 $ 2,974,000 $ 805,000 $ 3,779,000 2000 22,272,000 960,000 23,232,000 2001 2,374,000 868,000 3,242,000 2002 2,474,000 905,000 3,379,000 2003 2,608,000 983,000 3,591,000 </TABLE> Certain property and equipment of NHC and NHI are pledged as collateral on long-term debt or capital lease obligations. Other property and assets are available for use as collateral as needed. Certain loan agreements require maintenance of specified operating ratios as well as specified levels of cash held in escrow, working capital and shareowners' equity by NHC and NHI. All such covenants have been met by NHC, and management believes that NHI is in compliance with the loan covenants. Lease Commitments-- Operating expenses for the years ended December 31, 1998, 1997, and 1996 include expenses for leased premises and equipment under operating leases of $46,052,000, $26,396,000, and $24,753,000, respectively. See Notes 3 and 4 for the approximate future minimum rent commitments on non-cancelable operating leases with NHR and NHI. Construction and Financing Commitments-- NHC is committed to spend approximately $1,213,000 in 1999 for ongoing construction contracts. NHC's cash on hand, marketable securities, short-term notes receivable, operating cash flow and, as needed, its borrowing capacity are expected to be adequate to fund these commitments. Note 12 - Subordinated Convertible Notes: Notes-- At December 31, 1998, $714,000 of 6% subordinated convertible notes (the "notes") remain outstanding. Interest is payable quarterly, and the notes mature July 1, 2000. The notes are convertible at the option of the holder at any time into shares of NHC at a price of $15.2063 per share, subject to
adjustment for certain changes in the number of shares outstanding. The notes are convertible into NHC shares and also into an equal number of NHR shares. The notes may be redeemed at the option of NHC at any time. During 1998, $18,438,000 of the notes were converted into 1,212,504 shares. NHC has reserved an additional 46,954 shares of stock for conversion of the notes. 1997 Debentures-- On October 15, 1997 NHC issued $20,000,000 of 5.75% senior convertible subordinated debentures (the "1997 debentures") due June 30, 2004. At December 31, 1997, all of the 1997 debentures were converted into common shares of NHC at a conversion price of $36.00 per share. NHC issued 555,555 shares of common stock for the 1997 debenture conversions. Note 13 - Income Taxes: The provision (benefit) for income taxes is comprised of the following components: <TABLE> <CAPTION> Year Ended December 31 1998 1997 ---- ---- <S> <C> <C> Taxes Payable (in thousands) Federal $ 5,578 $ 4,736 State 797 13 6,375 4,749 Deferred Tax Benefit Federal (8,802) (3,859) State (1,258) (681) (10,060) (4,540) Income Tax Provision (Benefit) $ (3,685) $ 209 </TABLE> The deferred tax assets and liabilities, at the respective income tax rates, are as follows: <TABLE> <CAPTION> December 31 1998 1997 (in thousands) <S> <C> <C> Current deferred tax asset: Allowance for doubtful accounts receivable $ 2,552 $ 1,766 Accrued liabilities 1,583 1,689 4,135 3,455 Current deferred tax liability: Unrealized gains on marketable securities (1,337) (1,755) Other (154) (82) (1,491) (1,837) Net current deferred tax asset $ 2,644 $ 1,618 Noncurrent deferred tax asset: Financial reporting depreciation in excess of tax depreciation $ 870 $ --- Deferred gain on sale of assets 5,510 5,588 Deferred guarantee fees 1,146 1,146 Unearned insurance premium income --- 369 Net operating loss carryforwards 4,095 --- Other 753 244 12,374 7,347
Noncurrent deferred tax liability: Tax depreciation in excess of financial reporting depreciation $ --- $ (4,386) Other --- (39) --- (4,425) Net noncurrent deferred tax asset $ 12,374 $ 2,922 </TABLE> The provision for income taxes is different than the amount computed using the applicable statutory federal and state income tax rate as follows for the year ended December 31, 1998: Tax benefit at statutory rates $ (4,034) Amortization of goodwill 135 Other permanent differences 214 Effective tax benefit $ (3,685) Effective December 31, 1997, NHC recorded a deferred tax benefit related to the establishment of net deferred tax assets and liabilities in connection with its reorganization from a partnership to a corporation. During 1998 and 1997, NHC also recorded a current tax provision related to taxable income of corporate subsidiaries and other contingencies. As NHC was not a taxable entity as of or for the year ended December 31, 1996, no provisions or benefits for income taxes or deferred tax assets and liabilities were recorded. Note 14 - Stock Option Plan: NHC has incentive option plans which provide for the granting of options to key employees and directors to purchase shares of common stock at no less than market value on the date of grant. The options may be exercised immediately, but NHC may purchase the shares of stock at the grant price if employment is terminated prior to six years from the date of grant. The maximum term of the options is five years. The following table summarizes option activity: <TABLE> <CAPTION> Number of Weighted Average Shares/Units Exercise Price ------------ -------------- <S> <C> <C> Options outstanding December 31, 1995 377,500 $30.56 Options granted 15,000 38.63 Options exercised 2,500 11.25 Options outstanding December 31, 1996 390,000 30.99 Options granted 20,000 46.25 Options exercised 376,000 31.13 Options expired 9,000 21.67 Options outstanding December 31, 1997 25,000 40.05 Options granted 30,000 39.88 Options exercised 5,000 38.63 Options outstanding December 31, 1998 50,000 $40.25 </TABLE>
At December 31, 1998, all options outstanding are exercisable. Exercise prices on the exercisable options range from $24.88 to $46.13. The weighted average remaining contractual life of options outstanding at December 31, 1998 is 3.6 years. Additionally, NHC has an employee stock purchase plan which allows employees to purchase shares of stock of NHC through payroll deductions. The plan allows employees to terminate participation at any time. NHC has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). As a result, no compensation cost has been recognized in the consolidated statements of income for NHC's stock-based compensation plans. Management believes that any compensation cost attributable to stock-based compensation plans is immaterial. In connection with the exercise of certain stock options, NHC has received interest-bearing (ranging from 5% to 6.25%), full recourse notes in the amount of $16,807,000 at December 31, 1998. The notes are secured by shares of NHC, shares of NHR, or shares of NHI having a fair market value of not less than 150% of the amount of the note. The principal balances of the notes are reflected as a reduction of shareowners' equity in the consolidated financial statements. Note 15 - Contingencies and Guarantees: Litigation-- In March 1996, Florida Convalescent Centers, Inc. ("FCC"), an independent Florida corporation for whom NHC manages 16 licensed nursing centers in Florida, gave NHC notice of its intent not to renew a management contract at one of the centers. NHC responded by denying that FCC had that right. FCC then filed a Declaratory Judgment suit in the Circuit Court of the Twelfth Judicial Circuit in and for Sarasota County, Florida, requesting that the court interpret the parties' rights under their contractual arrangements, and naming NHC and its then general partners as defendants. Since the suit was filed, FCC amended its complaint four times, each amendment asserting new reasons why NHC's management agreements should be terminated. After lengthy pretrial proceedings, a jury was impaneled on October 28, 1998, but before opening arguments, the parties settled the litigation as follows: Under the terms of the settlement, NHC will purchase, subject to regulatory approval, two of the 16 long-term health care centers it currently manages for FCC in exchange for all of NHC's rights in deferred contingency fees receivable from FCC and for the assumption of approximately $14.3 million of long term debt. Additionally, NHC will pay a one-time cash settlement of $15 million. Furthermore, NHC has agreed to pay any adjustments to previously filed Medicare cost reports and routine cost limit exception requests related to these 16 centers and will be entitled to amounts received therefrom. NHC has also assumed certain additional liabilities from FCC, including contingencies related to ongoing litigation with former or current residents
of FCC's centers. Under the terms of the settlement, FCC has the right to cancel the management contracts for the remaining 14 centers, which cancellation may occur no earlier than June 30, 1999. The loss of the management contract and related revenues from these 14 facilities will have a material negative impact on NHC's results of operations, even after taking into consideration the purchase of two of the 16 long-term health care centers. The two centers to be purchased by NHC are Palm Garden of Pensacola, Florida with 180 beds and Palm Garden of Lake City, Florida with 120 beds. As of December 31, 1998, the purchase of these two centers is still awaiting regulatory approval; consequently, the assets to be purchased, the liabilities to be assumed and the results of operations of these centers are not included in NHC's consolidated financial statements. NHC is also a defendant in a lawsuit styled Braeuning, et al vs. National HealthCare L.P., et al filed "under seal" in the U.S. District Court of the Northern District of Florida on April 9, 1996. The court removed the seal from the complaint - but not the file itself - on March 20, 1997, and service of process occurred on July 8, 1997, with the government participating as an intervening plaintiff. By agreement, and with court approval, the suit has been moved from the Pensacola District Court to the Tampa, Florida, District Court. NHC has filed its answer denying the allegations. The suit alleges that NHC submitted cost reports and routine cost limit exception requests containing "fraudulent allocation of routine nursing services to ancillary service cost centers" and also alleges that NHC improperly allocated skilled nursing service hours in four managed centers, all in the state of Florida. The suit was filed under the Qui Tam provisions of the Federal False Claims Act, commonly referred to as the "Whistleblower Act". NHC has denied all allegations and believes the facts will vindicate its position. The individual plaintiff Braeuning has amended the suit to allege that he was "retaliatorily discharged" from his position due to the filing of the suit. In a March 13, 1998 order denying Braeuning's Motion for Summary Judgment on this issue, the court stated, "that the defendants have submitted a legitimate non-retaliatory reason for firing Mr. Braeuning that casts significant doubt on Mr. Braeuning's likelihood of success on the merits." The individual plaintiff and defendant have currently agreed to stay any proceedings on this allegation while NHC finalizes its internal review. In regard to the initial allegations contained in the lawsuit, NHC believes that the cost report information of its centers has been either appropriately filed or, upon amendment, will reflect adjustments only for the correction of unintentional misallocations. Prior to the filing of the suit, NHC had commenced an in-depth review of the nursing time allocation process at its owned, leased and managed centers. NHC's self audit process has been approved by the plaintiffs and NHC has retained a nationally recognized accounting firm to review the self audit process. It is anticipated that all cost report years in question will be reviewed prior to there being further action in this matter at the judicial level. The cost report periods under review include periods from 1991 through 1996, plus the 1997 reports as they were initially filed.
Adjustments to the reimbursable costs claimed will be the responsibility of the center where costs were incurred, whether owned, leased or managed by the Company. Under the terms of NHC's settlement with FCC as discussed previously, NHC has agreed to accept any adjustments to previously filed Medicare cost reports and routine cost limit exception requests related to the 16 FCC centers. Negative adjustments to other managed centers would reduce NHC's management fee (6% of net revenue), while adjustments to owned or leased centers would directly impact the Company's consolidated financial statements. NHC intends to continue it's revenue policy of not reflecting routine cost limit exception requests as income until the process, including cost report audits, is completed. NHC will continue to fully cooperate with the government in an attempt to determine dollar amounts involved, and will and is aggressively pursuing an amicable settlement. NHC cannot predict at this time the ultimate outcome of the suit. An adverse determination in the lawsuit could subject NHC to settlements which could have a material negative impact on the financial position, results of operations and cash flows of NHC. In October 1996, two managed centers in Florida were audited by representatives of the regional office of the Office of the Inspector General ("OIG"). As part of these audits, the OIG reviewed various records of the facilities relating to allocation of nursing hours and contracts with suppliers of outside services. At one center, the OIG indicated during an exit conference that it had no further questions but has not yet issued a final report. At the second facility, which is one of four named in the Braeuning lawsuit, the OIG determined that certain records were insufficient and NHC supplied the additional requested information. These audits have been incorporated into the lawsuit. Florida is one of the states in which governmental officials are conducting "Operation Restore Trust", a federal/state program aimed at detecting and eliminating fraud and abuse by providers in the Medicare and Medicaid programs. The OIG has increased its investigative actions in Florida (and has now opened a Tennessee office) as part of Operation Restore Trust. Costs associated with the aforementioned litigation have been included in the "litigation settlement and other charges" caption of the 1998 consolidated statement of income. The $28,084,000 includes the $15,000,000 one-time cash settlement related to the FCC lawsuit ($11,000,000 of which has been paid as of December 31, 1998) and an additional $13,084,000 charge for the assumption of liabilities, expected litigation charges and other liabilities. Health Care Legislation-- During 1997, the federal government enacted the Balanced Budget Act of 1997 ("BBA"), which requires that skilled nursing facilities transition to a Prospective Payment System ("PPS") under the Medicare program commencing with the first cost reporting period beginning on or after July 1, 1998. Although PPS went into effect for a small portion of NHC's long-term health care centers during 1998, PPS will be implemented for the vast majority of NHC's centers beginning January 1, 1999. PPS will significantly change the manner in which NHC's centers are paid for inpatient services provided to Medicare beneficiaries. Under PPS, Medicare will pay NHC's centers a fixed fee per Medicare patient per day, based on the acuity level of the patient, to cover all post-hospital extended care routine service costs, ancillary costs and capital related costs. The per diem rate will also cover substantially all
items and services furnished during a covered stay for which reimbursement is currently made separately under Medicare. PPS will be phased in over a three year period. During the phase-in, payments will be based on a blend of each center's specific historical costs and federally-established per diem rates that are based on an average of all U.S. skilled nursing facilities' historical costs. NHC has analyzed its center-specific historical costs, reviewed the expected federally-determined rates, and analyzed the current acuity level of Medicare patients in its centers. Based on such review and analyses, NHC has developed plans for each center to deliver care to Medicare patients at a lower cost and in a manner consistent with PPS requirements. These plans include a significant reduction in the number of therapy staff positions and various other cost reduction measures. Although NHC believes that it is positioned to operate effectively under PPS, if NHC is unable to execute the center-specific plans to reduce the cost of care to Medicare patients, PPS could have a material adverse effect on NHC's financial position, results of operations and cash flows. Professional Liability and Other Insurance-- NHC carries a professional liability insurance policy for coverage from liability claims and losses incurred in its health care business. The policy is a fixed premium and occurrence form policy and has no provisions for a retrospective refund or assessment due to actual loss experience. In the opinion of management, NHC's insurance coverage is adequate to cover settlement of outstanding claims against NHC. NHC has assumed certain risks related to health insurance and workers' compensation insurance claims of the employees of National and its managed facilities. The liability for reported claims and estimates for incurred but unreported claims of the managed facilities is $9,066,000 and $7,585,000 at December 31, 1998 and December 31, 1997, respectively. The liability is included in other current liabilities in the consolidated balance sheets. NHC remits for the claims with regards to National's employees utilized by NHC on a monthly basis. The amounts are subject to adjustment for actual claims incurred. Guarantees and Related Events-- In order to obtain management agreements and to facilitate construction or acquisition of certain health care centers which NHC manages for others, NHC has guaranteed some or all of the centers' first mortgage bond debt (principal and interest). For this service, NHC charges an annual guarantee fee of 1% to 2% of the outstanding principal balance guaranteed, which fee is in addition to NHC's management fee. The principal amount outstanding under the guarantees is approximately $67,919,000 (net of available debt service reserves) at variable and fixed interest rates with a weighted average rate of 5.0% at December 31, 1998. In management's opinion, these guarantee fees approximate fees that NHC would currently charge to enter into similar guarantees. All of the guaranteed indebtedness is secured by first mortgages, pledges of personal property, accounts receivable and, in certain instances, by the personal guarantees of the owners of the facilities. The borrower has granted second mortgages over the relevant properties in favor of NHC. Such rights may be enforced if NHC is required to pay under its guarantees.
NHI has guaranteed certain of the debts of NHC. NHC has agreed to indemnify and hold harmless NHI against any and all loss, liability or harm incurred by NHI as a result of having to perform under its guarantee of any or all of the guaranteed debt. Note 16 - Disclosures about Fair Value of Financial Instruments: The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practical to estimate that value: Cash and cash equivalents; Cash held by trustees; Accounts receivable; Bond reserve funds, mortgage replacement reserves and other deposits; Accounts payable and Accrued liabilities-- The fair value approximates the carrying amount because of the short maturity or the nature of these instruments. Marketable securities-- The fair value is estimated based on quoted market prices and is the same as the carrying amount. Notes receivable-- The fair value of NHC's notes receivable is estimated based on the current rates offered by NHC or comparable parties for the same or similar types of notes receivable of the same or similar maturities and is approximately the same as the carrying amount. Long-term debt and debt serviced by other parties-- The fair value is estimated based on the current rates offered to NHC for similar debt of the same maturities and is approximately the same as the carrying amounts. Subordinated convertible notes-- The fair values are estimated based on quoted market prices and approximate $727,790 and $70,531,000 at December 31, 1998 and December 31, 1997, respectively, as compared to carrying values of $714,000 and $19,152,000 at December 31, 1998 and December 31, 1997, respectively.
EXHIBIT 23 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports, included in this Form 10-K, into the Company's previously filed Registration Statement File No. 333-61451 and No. 333-61459 filed post-effective Amendment No. 1 to Form S-4 on Form S-8 Registration Statement No. 33-9881. ARTHUR ANDERSEN LLP Nashville, Tennessee March 22, 1999