SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 1998; or [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from ____________ to _____________. Commission File Number 1-10315 ------- HEALTHSOUTH CORPORATION ---------------------------------------------------- (Exact Name of Registrant as Specified in its Charter) Delaware 63-0860407 - - ------------------------------- ------------------- (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) ONE HEALTHSOUTH PARKWAY, BIRMINGHAM, ALABAMA 35243 ------------------------------------------------------------ (Address of Principal Executive Offices) (Zip Code) (205) 967-7116 -------------- (Registrant's Telephone Number, Including Area Code) Indicate by check mark whether the Registrant (1) has filed all Reports required to be filed by Section 13 or 15(d) of the Securities and 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at November 11, 1998 - - ------------------------ -------------------------------- COMMON STOCK, PAR VALUE 423,057,045 SHARES $.01 PER SHARE Page 1
HEALTHSOUTH CORPORATION AND SUBSIDIARIES QUARTERLY REPORT ON FORM 10-Q INDEX PART 1 -- FINANCIAL INFORMATION <TABLE> <CAPTION> Page ---- Item 1. Financial Statements <S> <C> Consolidated Balance Sheets -- September 30, 1998 (Unaudited) 3 and December 31, 1997 Consolidated Statements of Income (Unaudited) -- Three Months and Nine Months Ended September 30, 1998 and 1997 5 Consolidated Statements of Cash Flows (Unaudited) -- Nine Months Ended September 30, 1998 and 1997 6 Notes to Consolidated Financial Statements (Unaudited) -- Three Months and Nine Months Ended September 30, 1998 and 1997 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 PART II -- OTHER INFORMATION Item 1. Legal Proceedings 18 Item 2. Changes in Securities 18 Item 6. Exhibits and Reports on Form 8-K 19 </TABLE> Page 2
PART I -- FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS HEALTHSOUTH CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------------- ------------------- (Unaudited) ASSETS CURRENT ASSETS <S> <C> <C> Cash and cash equivalents $ 206,393 $ 148,073 Other marketable securities 3,716 4,326 Accounts receivable 1,041,487 745,994 Inventories, prepaid expenses, and other current assets 266,155 184,805 ------------------- ------------------- TOTAL CURRENT ASSETS 1,517,751 1,083,198 OTHER ASSETS 250,721 223,718 PROPERTY, PLANT AND EQUIPMENT--NET 2,296,074 1,850,765 INTANGIBLE ASSETS--NET 2,992,757 2,243,372 ------------------- ------------------- TOTAL ASSETS $ 7,057,303 $ 5,401,053 =================== =================== </TABLE> Page 3
HEALTHSOUTH CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (CONTINUED) (IN THOUSANDS) <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------------- ------------------- (Unaudited) LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES <S> <C> <C> Accounts payable $ 37,290 $ 124,058 Salaries and wages payable 110,042 121,768 Income taxes payable 1,506 92,507 Deferred income taxes 45,821 34,119 Accrued interest payable and other liabilities 165,519 97,506 Current portion of long-term debt 48,326 46,489 ------------------- ------------------- TOTAL CURRENT LIABILITIES 408,504 516,447 LONG-TERM DEBT 2,780,234 1,555,335 DEFERRED INCOME TAXES 71,276 76,613 DEFERRED REVENUE AND OTHER LONG-TERM LIABILITIES 8,275 1,538 MINORITY INTERESTS--LIMITED PARTNERSHIPS 151,736 93,692 STOCKHOLDERS' EQUITY: Preferred Stock, $.10 par value--1,500,000 shares authorized; issued and outstanding-- none 0 0 Common Stock, $.01 par value--600,000,000 shares authorized; 422,963,000 and 395,233,000 shares issued at September 30, 1998 and December 31, 1997, respectively 4,230 3,952 Additional paid-in capital 2,576,630 2,317,821 Retained earnings 1,072,074 853,641 Treasury stock (323) (323) Receivable from Employee Stock Ownership Plan (10,169) (12,247) Notes receivable from stockholders (5,164) (5,416) ------------------- ------------------- TOTAL STOCKHOLDERS' EQUITY 3,637,278 3,157,428 ------------------- ------------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 7,057,303 $ 5,401,053 =================== =================== </TABLE> See accompanying notes. Page 4
HEALTHSOUTH CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED - IN THOUSANDS, EXCEPT FOR PER SHARE DATA) <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------------------------- ------------------------------ 1998 1997 1998 1997 ---------------- ---------------- ---------------- ------------ <S> <C> <C> <C> <C> Revenues $ 1,047,422 $ 748,370 $ 2,897,567 $ 2,163,018 Operating unit expenses 645,624 464,143 1,785,752 1,354,082 Corporate general and administrative expenses 27,503 19,568 80,184 55,926 Provision for doubtful accounts 24,015 19,023 67,738 51,811 Depreciation and amortization 88,888 63,743 242,601 181,259 Merger costs 25,630 0 25,630 15,875 Loss on impairment of home health assets 105,339 0 105,339 0 Interest expense 46,126 27,765 103,044 81,180 Interest income (3,450) (1,439) (7,972) (3,761) ---------------- ---------------- ------------ ----------- 959,675 592,803 2,402,316 1,736,372 ---------------- ---------------- ------------ ----------- Income before income taxes and minority interests 87,747 155,567 495,251 426,646 Provision for income taxes 63,907 52,882 209,391 145,347 ---------------- ---------------- ------------ ----------- Income before minority interests 23,840 102,685 285,860 281,299 Minority interests (18,170) (16,766) (53,594) (49,481) ---------------- ---------------- ------------ ----------- Net income $ 5,670 $ 85,919 $ 232,266 $ 231,818 ================ ================ ============ =========== Weighted average common shares outstanding 422,649 340,919 407,414 336,374 ================ ================ ============ =========== Net income per common share $ 0.01 $ 0.25 $ 0.57 $ 0.69 ================ ================ ============ =========== Weighted average common shares outstanding -- assuming dilution 433,033 356,802 419,317 355,816 ================ ================ ============ =========== Net income per common share -- assuming dilution $ 0.01 $ 0.24 $ 0.55 $ 0.65 ================ ================ ============ =========== </TABLE> See accompanying notes. Page 5
HEALTHSOUTH CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED - IN THOUSANDS) <TABLE> <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, ----------------------------------- 1998 1997 ---------------- ---------------- OPERATING ACTIVITIES <S> <C> <C> Net income $ 232,266 $ 231,818 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 242,601 181,259 Provision for doubtful accounts 67,738 51,811 Income applicable to minority interests of limited partnerships 53,594 49,481 Merger costs 25,630 15,875 Loss on impairment of home health assets 105,339 0 Provision for deferred income taxes 13,145 9,614 Provision for deferred revenue 0 (390) Changes in operating assets and liabilities, net of effects of acquisitions: Accounts receivable (314,811) (150,138) Inventories, prepaid expenses and other current assets (65,862) (47,379) Accounts payable and accrued expenses 32,711 (72,247) ---------- --------- NET CASH PROVIDED BY OPERATING ACTIVITIES 392,351 269,704 INVESTING ACTIVITIES Purchases of property, plant and equipment (456,642) (262,110) Additions to intangible assets, net of effects of acquisitions (52,203) (66,641) Assets obtained through acquisitions, net of liabilities assumed (707,011) (234,394) Payments on purchase accounting accruals related to 1997 acquisitions and dispositions (295,508) 0 Changes in other assets (20,733) (25,849) Proceeds received on sale of other marketable securities 610 260 Investments in other marketable securities 0 (139) ---------- --------- NET CASH USED IN INVESTING ACTIVITIES (1,531,487) (588,873) </TABLE> Page 6
HEALTHSOUTH CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) (UNAUDITED - IN THOUSANDS) <TABLE> <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, ----------------------------------- 1998 1997 ---------------- ---------------- <S> <C> <C> FINANCING ACTIVITIES Proceeds from borrowings 2,389,272 569,978 Principal payments on long-term debt (1,198,548) (184,256) Proceeds from exercise of options 59,427 22,366 Reduction in receivable from Employee Stock Ownership Plan 2,078 1,901 Decrease in loans to stockholders 252 7 Proceeds from investment by minority interests 2,061 557 Payment of cash distributions to limited partners (57,086) (52,047) ----------- ----------- NET CASH PROVIDED BY FINANCING ACTIVITIES 1,197,456 358,506 ----------- ----------- INCREASE IN CASH AND CASH EQUIVALENTS 58,320 39,337 Cash and cash equivalents at beginning of period 148,073 150,071 ----------- ----------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 206,393 $ 189,408 =========== =========== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the year for: Interest $ 81,085 $ 77,237 Income taxes 280,835 106,699 </TABLE> Non-cash investing activities: During 1998, the Company issued 699,000 shares of its common stock with a market value of $19,397,000 as consideration for acquisitions accounted for as purchases. During 1998, the Company issued approximately 20,426,000 shares of its common stock as consideration for mergers (see Note 4). Non-cash financing activities: The holders of the Company's $115,000,000 in aggregate principal amount of 5% Convertible Subordinated Debentures due 2001 surrendered the Debentures for conversion into approximately 12,226,000 shares of the Company's Common Stock at various dates during 1997. During 1997, the Company had a two-for-one stock split on its common stock, which was effected in the form of a 100% stock dividend. The Company received a tax benefit from the disqualifying disposition of incentive stock options of $21,804,000 for the nine months ended September 30, 1998. See accompanying notes. Page 7
HEALTHSOUTH CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997 NOTE 1 -- The accompanying consolidated financial statements include the accounts of HEALTHSOUTH Corporation (the "Company") and its subsidiaries. This information should be read in conjunction with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. It is management's opinion that the accompanying consolidated financial statements reflect all adjustments (which are normal recurring adjustments, except as otherwise indicated) necessary for a fair presentation of the results for the interim period and the comparable period presented. NOTE 2 -- The Company has a $1,750,000,000 revolving credit facility with NationsBank, N.A. ("NationsBank") and other participating banks (the "1998 Credit Agreement"). The 1998 Credit Agreement replaced a previous $1,250,000,000 revolving credit agreement, also with NationsBank, consisting of a $350,000,000 two-year amortizing term note maturing on December 31, 1999, and a $900,000,000 revolving credit facility. In conjunction with the 1998 Credit Agreement, the Company also canceled its $350,000,000 364-day interim revolving credit facility with NationsBank. Interest on the 1998 Credit Agreement is paid based on LIBOR plus a predetermined margin, a base rate, or competitively bid rates from the participating banks. The Company is required to pay a fee based on the unused portion of the revolving credit facility ranging from 0.09% to 0.25%, depending on certain defined ratios. The principal amount is payable in full on June 22, 2003. The Company has provided a negative pledge on all assets under the 1998 Credit Agreement. On March 24, 1994, the Company issued $250,000,000 principal amount of 9.5% Senior Subordinated Notes due 2001 (the "Notes"). Interest is payable on April 1 and October 1. The Notes are senior subordinated obligations of the Company and, as such, are subordinated to all existing and future senior indebtedness of the Company. The net proceeds from the issuance of the Notes were used by the Company to pay down indebtedness outstanding under its existing credit facilities. On March 20, 1998, the Company issued $500,000,000 in 3.25% Convertible Subordinated Debentures due 2003 (the "3.25% Convertible Debentures") in a private placement. An additional $67,750,000 principal amount of the 3.25% Convertible Debentures was issued on March 31, 1998 to cover underwriters' overallotments. Interest is payable on April 1 and October 1. The 3.25% Convertible Debentures are convertible into Common Stock of the Company at the option of the holder at a conversion price of $36.625 per share, subject to adjustment upon the occurrence of certain events. The net proceeds from the issuance of the 3.25% Convertible Debentures were used by the Company to pay down indebtedness outstanding under its existing credit facilities. On June 22, 1998, the Company issued $250,000,000 in 6.875% Senior Notes due 2005 and $250,000,000 in 7.0% Senior Notes due 2008 (collectively, the "Senior Notes"). Interest is payable on June 15 and December 15 of each year, commencing on December 15, 1998. The Senior Notes are unsecured, unsubordinated obligations of the Company. The net proceeds from the issuance of the Senior Notes were used by the Company to pay down indebtedness outstanding under its existing credit facilities. Page 8
At September 30, 1998, and December 31, 1997, long-term debt consisted of the following: <TABLE> <CAPTION> September 30, December 31, 1998 1997 ----------------- ----------------- (in thousands) <S> <C> <C> Advances under the 1998 Credit Agreement $ 1,325,000 $ 1,175,000 9.5% Senior Subordinated Notes due 2001 250,000 250,000 3.25% Convertible Subordinated Debentures due 2003 567,750 0 6.875% Senior Notes due 2005 250,000 0 7.0% Senior Notes due 2008 250,000 0 Other long-term debt 185,810 176,824 ----------------- ----------------- 2,828,560 1,601,824 Less amounts due within one year 48,326 46,489 ----------------- ----------------- $ 2,780,234 $1,555,335 ================= ================= </TABLE> NOTE 3 -- Effective July 1, 1998, the Company acquired Columbia/HCA Healthcare Corporation's interests in 33 ambulatory surgery centers in a transaction accounted for as a purchase. Effective July 31, 1998, the Company entered into certain other arrangements to acquire substantially all of the economic benefit of Columbia/HCA's interests in one additional ambulatory surgery center. The transaction was valued at approximately $550,594,000. Also, during the first nine months of 1998, the Company acquired 97 outpatient rehabilitation facilities, one inpatient rehabilitation hospital, three outpatient surgery centers and 26 diagnostic imaging centers. The total purchase price of these acquired facilities was approximately $156,417,000. The Company also entered into non-compete agreements totaling approximately $22,502,000 in connection with these transactions. The cost in excess of the acquired facilities' net asset value was approximately $698,353,000. The results of operations (not material individually or in the aggregate) of these acquisitions are included in the consolidated financial statements from their respective acquisition dates. NOTE 4 -- On July 22, 1998, a wholly-owned subsidiary of the Company merged with National Surgery Centers, Inc. ("NSC"). A total of 20,426,261 shares of the Company's Common Stock were issued in connection with the transaction. At the time of the merger, NSC operated 40 outpatient surgery centers in 14 states. The NSC merger was accounted for as a pooling of interests. However, due to the immateriality of the merger, the Company's historical financial statements for all periods prior to July, 1998 have not been restated. Instead, stockholders' equity has been increased by $146,284,000 as of July 1, 1998, to reflect the effects of the merger. Costs and expenses of $25,630,000, primarily representing accounting, legal and financial advisory services, incurred by the Company in connection with the merger were recorded in operations during the quarter ending September 30, 1998, and reported as Merger Costs in the accompanying consolidated statements of income. The effects of conforming the accounting policies of the Company and NSC were not material. NOTE 5 -- During the third quarter of 1998, the Company adopted a plan to dispose of or otherwise discontinue substantially all of its home health operations, effective November 1, 1998. Such operations, which were acquired by the Company as portions of larger strategic acquisitions, are inconsistent with the Company's core business and growth strategy. Page 9
Accordingly, the Company recorded an impairment loss of approximately $105,339,000 during the quarter ending September 30, 1998. The loss represents the write-down of the home health assets, including goodwill, to their estimated fair value less the estimated costs to sell or otherwise dispose of the assets. Revenues related to the home health assets to be disposed of were approximately $73,071,000 and $63,407,000 for the nine months ending September 30, 1998 and 1997, respectively. NOTE 6 -- During the first nine months of 1998, the Company granted incentive and nonqualified stock options to certain Directors, employees and others for 574,000 shares of Common Stock at exercise prices ranging from $26.94 to $29.75 per share. Page 10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL The Company provides outpatient and rehabilitative healthcare services through its inpatient and outpatient rehabilitation facilities, surgery centers, diagnostic centers and medical centers. The Company has expanded its operations through the acquisition or opening of new facilities and satellite locations and by enhancing its existing operations. As of September 30, 1998, the Company had over 2,000 locations in 50 states, the United Kingdom and Australia, including approximately 1,290 outpatient rehabilitation locations, 131 inpatient rehabilitation facilities, four medical centers, 250 surgery centers, 139 diagnostic centers and approximately 200 locations providing other patient care services. The Company's revenues include net patient service revenues and other operating revenues. Net patient service revenues are reported at estimated net realizable amounts from patients, insurance companies, third-party payors (primarily Medicare and Medicaid) and others for services rendered. Revenues from third-party payors also include estimated retroactive adjustments under reimbursement agreements which are subject to final review and settlement by appropriate authorities. Management determines allowances for doubtful accounts and contractual adjustments based on historical experience and the terms of payor contracts. Net accounts receivable include only those amounts estimated by management to be collectible. The Company determines the amortization period of the cost in excess of net asset value of purchased facilities based on an evaluation of the facts and circumstances of each individual purchase transaction. The evaluation includes an analysis of historic and projected financial performance, an evaluation of the estimated useful life of the buildings and fixed assets acquired, the indefinite useful life of Certificates of Need and licenses acquired, the competition within local markets, lease terms where applicable, and the legal terms of partnerships where applicable. The Company utilizes independent appraisers and relies on its own management expertise in evaluating each of the factors noted above. With respect to the carrying value of the excess of cost over net asset value of purchased facilities and other intangible assets, the Company determines on a quarterly basis whether an impairment event has occurred by considering factors such as the market value of the asset, a significant adverse change in legal factors or in the business climate, adverse action by regulators, a history of operating losses or cash flow losses, or a projection of continuing losses associated with an operating entity. The carrying value of excess cost over net asset value of purchased facilities and other intangible assets will be evaluated if the facts and circumstances suggest that it has been impaired. If this evaluation indicates that the value of the asset will not be recoverable, as determined based on the undiscounted cash flows of the entity acquired over the remaining amortization period, the Company's carrying value of the asset will be reduced by the estimated shortfall of cash flows to the estimated fair market value. The Company, in many cases, operates more than one site within a market. In such markets, there is customarily an outpatient center or inpatient facility with associated satellite outpatient locations. For purposes of the following discussion and analysis, same store operations are measured on locations within markets in which similar operations existed at the end of the period and include the operations of additional locations opened within the same market. New store operations are measured on locations within new markets. The Company may, from time to time, close or consolidate similar locations in multi-site markets to obtain efficiencies and respond to changes in demand. Substantially all of the Company's revenues are derived from private and governmental third-party payors. The Company's reimbursement from governmental third-party payors is based upon cost reports and other reimbursement mechanisms which require the application and interpretation of complex regulations and policies, and such reimbursement is subject to various levels of review and adjustment by fiscal intermediaries and others, which may affect the final determination of reimbursement. In addition, there are increasing pressures from many payor sources to control healthcare costs and to reduce or limit Page 11
increases in reimbursement rates for medical services. There can be no assurance that payments under governmental and third-party payor programs will remain at levels comparable to present levels. In addition, there have been, and the Company expects that there will continue to be, a number of proposals to limit Medicare reimbursement for certain services. The Company cannot now predict whether any of these proposals will be adopted or, if adopted and implemented, what effect such proposals would have on the Company. Changes in reimbursement policies or rates by private or governmental payors could have an adverse effect on the future results of operations of the Company. RESULTS OF OPERATIONS -- THREE MONTHS ENDED SEPTEMBER 30, 1998 The Company operated approximately 1,290 outpatient locations (which includes base facilities and satellites) at September 30, 1998, compared to approximately 880 outpatient locations at September 30, 1997. In addition, the Company operated 131 inpatient rehabilitation facilities, four medical centers, 250 surgery centers, and 139 diagnostic centers at September 30, 1998, compared with 99 inpatient facilities, four medical centers, 174 surgery centers and 77 diagnostic centers at September 30, 1997. The Company's operations generated revenues of $1,047,422,000 for the quarter ended September 30, 1998, an increase of $299,052,000, or 40.0%, as compared to the same period in 1997. The increase in revenues is primarily attributable to increases in patient volume and the addition of new outpatient, inpatient, diagnostic and surgery centers. Same store revenues for the quarter ended September 30, 1998, were $806,959,000, an increase of $58,589,000, or 7.8%, as compared to the same period in 1997. New store revenues were $240,463,000. Revenues generated from patients under Medicare and Medicaid plans respectively accounted for 35.1% and 2.9% of revenue for the third quarter of 1998, compared to 36.4% and 2.3% for the same period in 1997. Revenues from any other single third-party payor were not significant in relation to the Company's revenues. During the third quarter of 1998, same store outpatient visits, inpatient days, surgical cases and diagnostic cases increased 15.5%, 6.7%, 4.2% and 10.9%, respectively. Revenue per outpatient visit, inpatient day, surgical case and diagnostic case for same store operations increased (decreased) by (0.2)%, 0.1%, (0.8)% and (0.5)%, respectively. Operating expenses, at the operating unit level, were $645,624,000, or 61.6% of revenues, for the quarter ended September 30, 1998, compared to 62.0% of revenues for the third quarter of 1997. The decrease in operating expenses as a percentage of revenues is primarily attributable to the 7.8% increase in same store revenues noted above. In same store operations, the incremental costs associated with increased revenues are significantly less as a percentage of those increased revenues. Same store operating expenses were $496,279,000, or 61.5% of comparable revenue. New store operating expenses were $149,345,000, or 62.1% of comparable revenue. Corporate general and administrative expenses increased from $19,568,000 during the 1997 quarter to $27,503,000 during the 1998 quarter. As a percentage of revenue, corporate general and administrative expenses were 2.6% in the 1997 and 1998 quarter. The provision for doubtful accounts was $24,015,000, or 2.3% of revenues, for the third quarter of 1998, compared to $19,023,000, or 2.5% of revenues, for the same period in 1997. Management believes that this provision is adequate to cover any uncollectible revenues. Depreciation and amortization expense was $88,888,000 for the quarter ended September 30, 1998, compared to $63,743,000 for the same period in 1997. The increase represents the investment in additional assets by the Company. Interest expense was $46,126,000 for the quarter ended September 30, 1998, compared to $27,765,000 for the quarter ended September 30, 1997. For the third quarter of 1998, interest income was $3,450,000, compared to $1,439,000 for the third quarter of 1997. As a result of the National Surgery Centers, Inc. acquisition, the Company recognized $25,630,000, primarily representing accounting, legal and financial advisory services, in merger costs during the quarter ending September 30, 1998. During the third quarter of 1998, the Company adopted a plan to dispose of or otherwise discontinue substantially all of its home health operations, effective November 1, 1998. Such operations, which were acquired by the Company as portions of larger strategic acquisitions, are inconsistent with the Page 12
Company's core business and growth strategy. Accordingly, the Company recorded an impairment loss of approximately $105,339,000 during the quarter ending September 30, 1998. The loss represents the write-down of the home health assets, including goodwill, to their estimated fair value less the estimated costs to sell or otherwise dispose of the assets. Income before minority interests and income taxes for the third quarter of 1998 was $87,747,000, compared to $155,567,000 for the same period in 1997. Minority interests decreased income before income taxes by $18,170,000 for the quarter ended September 30, 1998, compared to decreasing income before income taxes by $16,766,000 for the third quarter of 1997. The provision for income taxes for the third quarter of 1998 was $63,907,000, compared to $52,882,000 for the same period in 1997. Excluding the tax effects of the merger costs and impairment loss described above, the effective tax rates for the quarters ending September 30, 1998 and 1997 were 39.1% and 38.1%, respectively. Net income for the third quarter of 1998 was $5,670,000, compared to $85,919,000 for the third quarter of 1997. RESULTS OF OPERATIONS -- NINE MONTHS ENDED SEPTEMBER 30, 1998 Revenues for the nine months ended September 30, 1998, were $2,897,567,000, an increase of $734,549,000, or 34.0%, over the nine months ended September 30, 1997. Same store revenues were $2,377,806,000, an increase of $214,788,000, or 9.9%, as compared to the same period in 1997. New store revenues were $519,761,000. Revenues generated from patients under Medicare and Medicaid plans respectively accounted for 35.9% and 2.8% of revenue for the first nine months of 1998, compared to 37.4% and 2.3% for the same period in 1997. Revenues from any other single third-party payor were not significant in relation to the Company's revenues. During the first nine months of 1998, same store outpatient visits, inpatient days, surgical cases and diagnostic cases increased 16.0%, 8.9%, 7.2% and 11.0%, respectively. Revenue per outpatient visit, inpatient day, surgical case and diagnostic case for same store operations increased (decreased) by 0.7%, 0.3%, (0.9)% and (0.5)%, respectively. Operating expenses, at the operating unit level, were $1,785,752,000, or 61.6% of revenues, for the nine months ended September 30, 1998, as compared to $1,354,082,000, or 62.6% of revenues, for the first nine months of 1997. Same store operating expenses were $1,457,721,000, or 61.3% of comparable revenue. New store operating expenses were $328,031,000, or 63.1% of comparable revenue. As a result of its acquisition of Health Images, Inc., the Company recognized $15,875,000, primarily representing accounting, legal and financial advisory services, in merger costs during the first quarter of 1997. Net income for the nine months ended September 30, 1998, was $232,266,000, compared to $231,818,000 for the same period in 1997. LIQUIDITY AND CAPITAL RESOURCES As of September 30, 1998, the Company had working capital of $1,109,247,000, including cash and marketable securities of $210,109,000. Working capital at December 31, 1997, was $566,751,000, including cash and marketable securities of $152,399,000. For the first nine months of 1998, cash provided by operations was $392,351,000, compared to $269,704,000 for the same period in 1997. Additions to property, plant, and equipment and acquisitions accounted for $456,642,000 and $707,011,000, respectively, during the first nine months of 1998. Those same investing activities accounted for $262,110,000 and $234,394,000, respectively, in the same period in 1997. Financing activities provided $1,197,456,000 and $358,506,000 during the first nine months of 1998 and 1997, respectively. Net borrowing proceeds (borrowing less principal reductions) for the first nine months of 1998 and 1997 were $1,190,724,000 and $385,722,000, respectively. Accounts receivable were $1,041,487,000 at September 30, 1998, compared to $745,994,000 at December 31, 1997. The number of days of average revenues in average receivables at September 30, 1998, was 80.7, compared to 75.7 days of average revenues in average receivables at December 31, 1997. The concentration of net accounts receivable from patients, third-party payors, insurance companies and others at September 30, 1998, is consistent with the related concentration of revenues for the period then ended. Page 13
The Company has a $1,750,000,000 revolving credit facility with NationsBank, N.A. ("NationsBank") and other participating banks (the "1998 Credit Agreement"). The 1998 Credit Agreement replaced a previous $1,250,000,000 revolving credit agreement, also with NationsBank, consisting of a $350,000,000 two-year amortizing term note maturing on December 31, 1999, and a $900,000,000 revolving credit facility. In conjunction with the 1998 Credit Agreement, the Company also canceled its $350,000,000 364-day interim revolving credit facility with NationsBank. Interest on the 1998 Credit Agreement is paid based on LIBOR plus a predetermined margin, a base rate, or competitively bid rates from the participating banks. The Company is required to pay a fee based on the unused portion of the revolving credit facility ranging from 0.09% to 0.25%, depending on certain defined ratios. The principal amount is payable in full on September 22, 2003. The Company has provided a negative pledge on all assets under the 1998 Credit Agreement. The effective interest rate on the average outstanding balance under the 1998 Credit Agreement was 6.18% for the nine months ended September 30, 1998, compared to the average prime rate of 8.50% during the same period. At September 30, 1998, the Company had drawn $1,325,000,000 under the 1998 Credit Agreement. On March 20, 1998, the Company issued $500,000,000 in 3.25% Convertible Subordinated Debentures due 2003 (the "3.25% Convertible Debentures") in a private placement. An additional $67,750,000 principal amount of the 3.25% Convertible Debentures was issued on March 31, 1998 to cover underwriters' overallotments. Interest is payable on April 1 and October 1 of each year, commencing on October 1, 1998. The Convertible Debentures are convertible into Common Stock of the Company at the option of the holder at a conversion price of $36.625 per share, subject to the adjustment upon the occurrence of certain events. The net proceeds from the issuance of the Convertible Debentures were used by the Company to pay down indebtedness outstanding under its other existing credit facilities. On June 22, 1998, the Company issued $250,000,000 in 6.875% Senior Notes due 2005 and $250,000,000 in 7.0% Senior Notes due 2008 (collectively, the "Senior Notes"). Interest is payable on June 15 and December 15 of each year, commencing on December 15, 1998. The Senior Notes are unsecured, unsubordinated obligations of the Company. The net proceeds from the issuance of the Senior Notes were used by the Company to pay down indebtedness outstanding under its existing credit facilities. The Company intends to pursue the acquisition or development of additional healthcare operations, including comprehensive outpatient rehabilitation facilities, ambulatory surgery centers, inpatient rehabilitation facilities and companies engaged in the provision of outpatient surgery and rehabilitation-related services, and to expand certain of its existing facilities. While it is not possible to estimate precisely the amounts which will actually be expended in the foregoing areas, the Company anticipates that over the next twelve months, it will spend approximately $150,000,000 on maintenance and expansion of its existing facilities and approximately $300,000,000 on development of the Integrated Service Model, pursuant to which the Company plans to utilize its services in particular markets to provide an integrated continuum of coordinated care. Although the Company is continually considering and evaluating acquisitions and opportunities for future growth, the Company has not entered into any agreements with respect to material future acquisitions. The Company believes that existing cash, cash flow from operations, and borrowings under the 1998 Credit Agreement will be sufficient to satisfy the Company's estimated cash requirements for the next twelve months and for the reasonably foreseeable future. Inflation in recent years has not had a significant effect on the Company's business, and is not expected to adversely affect the Company in the future unless it increases significantly. EXPOSURES TO MARKET RISK The Company is exposed to market risk related to changes in interest rates. Because of its favorable borrowing arrangements and current market conditions, the Company currently does not use derivatives, such as swaps or caps, to alter the interest characteristics of its debt instruments and investment securities. Page 14
The impact on earnings and value of market risk-sensitive financial instruments (principally marketable security investments and long-term debt) is subject to change as a result of movements in market rates and prices. The Company uses sensitivity analysis models to evaluate these impacts. The Company's investment in marketable securities was $3,716,000 at September 30, 1998, which represents less than 1% of total assets at that date. These securities are generally short-term, highly-liquid instruments and, accordingly, their fair value approximates cost. Earnings on investments in marketable securities are not significant to the Company's results of operations, and therefore any changes in interest rates would have a minimal impact on future pre-tax earnings. With respect to the Company's interest-bearing liabilities, approximately $1,325,000,000 in long-term debt at September 30, 1998 is subject to variable rates of interest, while the remaining balance in long-term debt of $1,503,560,000 is subject to fixed rates of interest (see Note 2 of "Notes to Consolidated Financial Statements" for further description). The fair value of the Company's total long-term debt, based on discounted cash flow analyses, approximates its carrying value at September 30, 1998. Based on a hypothetical 1% increase in interest rates, the potential losses in future annual pre-tax earnings would be approximately $13,250,000. The impact of such a change on the carrying value of long-term debt would not be significant. These amounts are determined considering the impact of the hypothetical interest rates on the Company's borrowing cost and long-term debt balances. These analyses do not consider the effects, if any, of the potential changes in the overall level of economic activity that could exist in such an environment. Further, in the event of a change of significant magnitude, management would expect to take actions intended to further mitigate its exposure to such change. Foreign operations, and the related market risks associated with foreign currency, are currently insignificant to the Company's results of operations and financial position. COMPUTER TECHNOLOGIES AND YEAR 2000 COMPLIANCE The Company is aware of the issues associated with the programming code in existing computer systems as the year 2000 approaches. Many existing computer programs use only two digits to identify a year in the date field. The issue is whether such code exists in the Company's mission-critical applications and if that code will produce accurate information to date-sensitive calculations after the turn of the century. The Company is involved in an extensive, ongoing program to identify and correct problems arising from the year 2000 issues. The program is broken down into the following categories: (1) mission-critical computer applications which are internally maintained by the Company's information technology department; (2) mission-critical computer applications which are maintained by third-party vendors; (3) non-mission-critical applications, whether internally or externally maintained; (4) hardware; (5) embedded applications which control certain medical and other equipment; (6) computer applications of its significant suppliers; and (7) computer applications of its significant payors. Mission-critical computer applications are those which are integral to the Company's business mission, which have no reasonable manual alternative for producing the same information and results, and the failure of which to produce accurate information and results would have a significant adverse impact on the Company. Such applications include the Company's general business systems and its patient billing systems. Most of the Company's clinical applications are not considered mission-critical, because reasonable manual alternatives are available to produce the same information and results for as long as necessary. The Company's review of its internally maintained mission-critical applications revealed that such applications contained very few date-sensitive calculations. The revisions to these applications have been completed and testing is being conducted during November and December, 1998. Implementation is scheduled for the first quarter of 1999. The budget for this project is approximately $150,000. Page 15
The Company's general business applications are all licensed from and maintained by the same vendor. All such applications are already year 2000 compliant. The Company has received written confirmation from the vendors of its other externally maintained mission-critical applications that such applications are currently year 2000 compliant or will be made year 2000 compliant by the end of 1998. The cost to be incurred by the Company related to externally maintained applications is not currently expected to be material. The Company has reviewed all of its non-mission-critical applications and determined that some of these applications are not year 2000 compliant and will not be made to be compliant. In such cases, the Company has developed manual alternatives to produce the information that such systems currently produce. The incremental cost of the manual systems is not currently estimated to be material. The Company plans to evaluate the effectiveness of the manual systems before any decisions are made on the replacement of the non-compliant applications. The Company has engaged a consultant to test all of its computer hardware for year 2000 compliance at a cost of approximately $800,000. The consultant is currently testing the computer hardware at nine pilot sites. The results of the pilot test will be available by November 30, 1998. Testing will begin at the remainder of the Company's sites in January 1999. Results from their test are expected to be available by March 31, 1999. The Company has regularly upgraded its significant servers and hardware platforms. Therefore, it is expected that the consultant's tests will only reveal that the Company's older personal computers are not year 2000 compliant. Once the results of the tests are available, the Company will determine which hardware components are necessary to replace and will develop a plan to do so. The cost of such replacements cannot be estimated until the plan is developed. The Company has not completed its review of embedded applications which control certain medical and other equipment. The Company expects to complete this review during the fourth quarter of 1998. The nature of the Company's business is such that any failure of these type applications is not expected to have a material adverse effect on its business. In particular, the Company has focused on reviewing and testing those applications the failure of which would be likely to cause a significant risk of death or serious injury to patients under treatment in the Company's facilities, and the Company believes that, because of the types of services it primarily provides and the nature of its patient population, there is little likelihood of such an event occurring because of the failure of an embedded application. The Company has sent inquiries to its significant suppliers of equipment and medical supplies concerning the year 2000 compliance of their significant computer applications. Responses have been received from over 85% of those suppliers, and no significant problems have been identified. Second requests have been mailed to all non-respondents. The Company has also sent inquiries to its significant third-party payors. Responses have been received from payors representing over 75% of the Company's revenues. Such responses indicate that these payors' systems will be year 2000 compliant. Second requests were mailed to all non-respondents during October 1998. The Company will continue to evaluate year 2000 risks with respect to such payors as additional responses are received. In that connection, it should be noted that substantially all of the Company's revenues are derived from reimbursement by governmental and private third-party payors, and that the Company is dependent upon such payors' evaluation of their year 2000 compliance status to assess such risks. If such payors are incorrect in their evaluation of their own year 2000 compliance status, this could result in delays or errors in reimbursement to the Company by such payors, the effects of which could be material to the Company. Guidance from the Securities and Exchange Commission requires the Company to describe its "reasonably likely worst case scenario" in connection with year 2000 issues. As discussed above, while there is always the potential risk of serious injury or death resulting from a failure of embedded applications in medical and other equipment used by the Company, the Company does not believe that such events are reasonably likely to occur. The Company believes that the most reasonably likely worst case to which it would be exposed is that, notwithstanding the Company's attempts to obtain year 2000 Page 16
compliance assurance from third-party payors, there is a material failure in such payors' systems which prevents or substantially delays reimbursement to the Company for its services. In such event, the Company would be forced to rely on cash on hand and available borrowing capacity to the extent of any shortfall in reimbursment, and could be forced to incur additional costs for personnel and other resources necessary to resolve any payment issues. It is not possible at this time to predict the nature or amount of such costs or the materiality of any reimbursement issues that may arise as a result of the failure of payors' payment systems, the effect of which could be substantial. The Company continues to endeavor to obtain reliable information from its payors as to their compliance status, and will attempt to adopt and revise its contingency plans for dealing with payment issues if, as and when such issues become susceptible of prediction. Based on the information currently available, the Company believes that its risk associated with problems arising from year 2000 issues is not significant. However, because of the many uncertainties associated with year 2000 compliance issues, and because the Company's assessment is necessarily based on information from third-party vendors, payors and suppliers, there can be no assurance that the Company's assessment is correct or as to the materiality or effect of any failure of such assessment to be correct. The Company will continue with its assessment process as described above and, to the extent that changes in such assessment require it, will attempt to develop alternatives or modifications to its compliance plan described above. There can, however, be no assurance that such compliance plan, as it may be changed, augmented or modified from time to time, will be successful. FORWARD-LOOKING STATEMENTS Statements contained in this Quarterly Report on Form 10-Q which are not historical facts are forward-looking statements. In addition, the Company, through its senior management, from time to time makes forward-looking public statements concerning its expected future operations and performance and other developments. Such forward-looking statements are necessarily estimates reflecting the Company's best judgment based upon current information and involve a number of risks and uncertainties, and there can be no assurance that other factors will not affect the accuracy of such forward-looking statements. While it is impossible to identify all such factors, factors which could cause actual results to differ materially from those estimated by the Company include, but are not limited to, changes in the regulation of the healthcare industry at either or both of the federal and state levels, changes in reimbursement for the Company's services by governmental or private payors, competitive pressures in the healthcare industry and the Company's response thereto, the Company's ability to obtain and retain favorable arrangements with third-party payors, unanticipated delays in the Company's implementation of its Integrated Service Model, general conditions in the economy and capital markets, and other factors which may be identified from time to time in the Company's Securities and Exchange Commission filings and other public announcements. Page 17
PART II -- OTHER INFORMATION Item 1. LEGAL PROCEEDINGS. The Company has been served with certain lawsuits filed beginning September 30, 1998 which purport to be class actions under the federal and Alabama securities laws. Such lawsuits were filed following a decline in the Company's stock price at the end of the third quarter of 1998. Three of the suits have been filed in the United States District Court for the Northern District of Alabama. Robert M. Gordon, et al., v. HEALTHSOUTH Corporation, et al., Civil Action No. 98-J-2634-S, and Twin Plus LLC, et al. v. HEALTHSOUTH Corporation, et al., Civil Action No. 98-PWG-2695-S, are identical complaints filed against the Company and certain of its officers and directors alleging that, during the period August 12, 1997 through September 30, 1998, the defendants misrepresented or failed to disclose certain material facts concerning the Company's business and financial condition in order to artificially inflate the price of the Company's Common Stock and issued or sold shares of such stock during the purported class period, all allegedly in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Irene Rigas, et al. v. HEALTHSOUTH Corporation, et al., Civil Action No. 98-RRA-2777-S, is substantially identical to the Gordon and Twin Plus complaints, except that the named plaintiffs therein purport to represent separate subclasses consisting of former stockholders of Horizon/CMS Healthcare Corporation and National Surgery Centers, Inc. who received shares of the Company's Common Stock in connection with the Company's acquisition of those entities and assert additional claims under Section 11 of the Securities Act of 1933 with respect to the registration of securities issued in those acquisitions. A fourth suit, Peter J. Petrunya v. HEALTHSOUTH Corporation, et al., Civil Action No. 98-05931, has been filed in the Circuit Court for Jefferson County, Alabama, and alleges that during the period July 16, 1996 through September 30, 1998 the defendants misrepresented or failed to disclose certain material facts concerning the Company's business and financial condition, allegedly in violation of Sections 8-6-17 and 8-6-19 of the Alabama Securities Act. Based upon information in the media, the Company believes that additional similar suits may have been filed, but the Company has not been served with any such suits. Additionally, a suit styled Dennis Family Trust v. Richard M. Scrushy, et al., Civil Action No. 98-06592, has been filed in the Circuit Court for Jefferson County, Alabama, purportedly as a derivative action on behalf of the Company. That suit largely replicates the allegations of the federal actions described in the preceding paragraph and alleges that the current directors of the Company, certain former directors and certain officers of the Company breached their fiduciary duties to the Company and engaged in other allegedly tortious conduct. The Company believes that all claims asserted in the above suits are without merit, and expects to vigorously defend against such claims. Because such suits have only recently been filed, the Company cannot currently predict the outcome of any such suits or the magnitude of any potential loss if the Company's defense is unsuccessful. Item 2. CHANGES IN SECURITIES. (c) Recent Sales of Unregistered Securities During the three months ended September 30, 1998, the Company issued 56,624 shares of its Common Stock in a transaction not registered under the Securities Act of 1933. Such shares were issued effective July 16, 1998, to RPI, Inc. in connection with the Company's acquisition by merger of RPI, Inc.'s subisidiary Sigma Health Properties, Page 18
Inc., the general partner of a partnership which owned the building in which the Company's Tallahassee, Florida rehabilitation hospital operates. Such shares were issued in reliance upon the exemption provided by Section 4(2) of the Securities Act, inasmuch as the transaction did not involve any public offering. Item 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits 11. Computation of Income Per Share (unaudited) 27. Financial Data Schedule (b) Reports on Form 8-K The Company filed no Current Reports on Form 8-K during the three months ended September 30, 1998. No other items of Part II are applicable to the Registrant for the period covered by this Quarterly Report on Form 10-Q. Page 19
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized. HEALTHSOUTH CORPORATION ----------------------- (Registrant) Date: November 16, 1998 RICHARD M. SCRUSHY -------------------------- Richard M. Scrushy Chairman of the Board and Chief Executive Officer Date: November 16, 1998 MICHAEL D. MARTIN -------------------------- Michael D. Martin Executive Vice President, Chief Financial Officer and Treasurer Page 20