ITEM 1. BUSINESS
Introductory Summary.
Advocat Inc. provides long-term care services to nursing home patients in eight states, primarily in the Southeast. Unless the context indicates otherwise, references herein to “Advocat,” “the Company,” “we,” “us” and “our” include Advocat Inc. and all of our subsidiaries.
The long-term care profession encompasses a broad range of non-institutional and institutional services. For those among the elderly requiring temporary or limited special services, a variety of home care options exist. As needs for assistance in activities of daily living develop, assisted living facilities become the most viable and cost effective option. For those among the elderly requiring much more intensive care, skilled nursing facility care becomes the only viable option. We have chosen to focus primarily on our skilled nursing centers and to specialize in this aspect of the long term care continuum.
Our objective is to become the provider of choice of health care and related services to the elderly in the communities in which we operate. We will continue to implement our operating strategy of (i) providing a broad range of cost-effective elder care services; (ii) increasing occupancy in our nursing centers through physical plant improvements and an increased emphasis on marketing efforts; (iii) improving the quality of payor mix; and (iv) clustering our operations on a regional basis.
Our principal executive offices are located at 1621 Galleria Boulevard, Brentwood, TN 37027. Our telephone number at that address is 615.771.7575, and our facsimile number is 615.771.7409. Our web-site is located at www.irinfo.com/AVC. The information on our web-site does not constitute part of this Annual Report on Form 10-K.
Nursing Centers and Services.
Advocat provides a broad range of long-term care services to the elderly including skilled nursing, ancillary health care services and assisted living. In addition to the nursing and social services usually provided in long-term care centers, we offer a variety of rehabilitative, nutritional, respiratory, and other specialized ancillary services. As of December 31, 2006, our continuing operations include 43 nursing centers containing 4,505 licensed nursing beds and 66 assisted living units.
Our nursing centers range in size from 48 to 180 licensed nursing beds. The following table summarizes certain information with respect to the nursing centers we own or lease as of December 31, 2006:
(1)
The number of “Licensed beds” is based on the licensed capacity of the facility. The Company reports its occupancy based on licensed beds. The number of “Available Beds” represents “licensed beds” less beds removed from service. “Available beds” is subject to change based upon the needs of the facilities, including configuration of patient rooms and offices, status of beds (private, semi-private, ward, etc.) and renovations.
Our nursing centers provide skilled nursing health care services, including room and board, nutrition services, recreational therapy, social services, and housekeeping and laundry services. Our nursing centers dispense medications prescribed by the patients’ physicians, and a plan of care is developed by professional nursing staff for each resident. We also provide for the delivery of ancillary medical services at the nursing centers we operate. These specialty services include rehabilitation therapy services, such as audiology, speech, occupational and physical therapies, which are provided through licensed therapists and registered nurses, and the provision of medical supplies, nutritional support, infusion therapies, and related clinical services. The significant majority of these services are provided using our internal resources and clinicians.
Within the framework of a nursing center, we may provide other specialty care, including:
Life Steps Unit. Six of our nursing centers have units designated as Life Steps Units, our designation for patients requiring short term rehabilitation following an incident such as a stroke or bone fracture. These units specialize in short term rehabilitation with the goal of returning the patient to their previous level of functionality. These units provide enhanced services with emphasis on upgraded amenities including electric beds, televisions, phones at bedside and feature a separate entrance for guests and visitors. The design and programming on the unit appeals to the generally younger resident who intends to return home following intensive rehabilitation. Specialized therapeutic treatment regimens include orthopedic rehabilitation, neurological rehabilitation and complex medical rehabilitation. While these patients generally have a shorter length of stay, the intensive level of rehabilitation generally results in higher levels of reimbursement.
Lighthouse Unit. Thirteen of our nursing centers have Lighthouse Units, our designation for advanced care for dementia related disorders, including Alzheimer’s disease. The goal of the units is to provide a safe, homelike and supportive environment for cognitively impaired patients, utilizing an interdisciplinary team approach. Family and community involvement compliment structured programming in the secure environment instrumental in fostering as much resident independence as possible despite diminished capacity.
Assisted Living Units. Four of our nursing centers have units designated for assisted living patients, ranging in size from 2 to 35 units. These units may be a subset of the facility or a separate freestanding building on the nursing center campus. Services and accommodations include central dining facilities, recreational areas, social programs, housekeeping, laundry and maintenance service, emergency call systems, special features for handicapped persons and transportation to shopping and special events. Generally, basic care and support services can be offered more economically in an assisted living facility than either in a nursing home or through home health care assistance.
Other Specialty Programming. We implement other specialty programming based on a center’s specific needs. We have developed one adult day care center on the campus of a nursing center. We have developed specialty programming for bariatric patients (generally, patients weighing more than 350 pounds). These individuals have unique psychosocial and equipment needs.
Continuous Quality Improvement. We have in place a Continuous Quality Improvement (“CQI”) program, which is focused on identifying opportunities for improvement of all aspects of the care provided in a center, as well as overseeing the initiation and effectiveness of interventions. The CQI program was designed to meet accreditation standards and to exceed state and federal government regulations. We conduct monthly audits to monitor adherence to the standards of care established by the CQI program at each center which we operate. The facility administrator, with assistance from regional nursing personnel, is primarily responsible for adherence to our quality improvement standards. In that regard, the annual operational objectives established by each facility administrator include specific objectives with respect to quality of care. Performance of these objectives is evaluated quarterly by the regional vice president or manager, and each facility administrator’s incentive compensation is based, in part, on the achievement of the specified quality objectives. A major component of our CQI program is employee empowerment initiatives, with particular emphasis placed on selection, recruitment, retention and recognition programs. Our administrators and managers include employee retention and turnover goals in the annual facility, regional and personal objectives. We also have established a quality improvement committee consisting of nursing representatives from each region. This committee periodically reviews our quality improvement programs and conducts facility audits.
Organization. Our long-term care facilities are currently organized into six regions, each of which is supervised by a regional vice president. The regional vice president is generally supported by specialists in several functions, including nursing, human resources, marketing, receivable management and clerical, all of whom are employed by us. The day-to-day operations of each owned or leased nursing center are supervised by an on-site, licensed administrator. The administrator of each nursing center is supported by other professional personnel, including a medical director, who assists in the medical management of the facility, and a director of nursing, who supervises a staff of registered nurses, licensed practical nurses, and nurses aides. Other personnel include therapy, dietary, activities and social service, housekeeping, laundry and maintenance, and a business office staff. All personnel at the leased or owned facilities, including the administrators, are our employees.
Operating and Growth Strategy.
Our operating objective is to be the provider of choice of health care and related services to the elderly in the communities in which we operate. To achieve our objective we:
Provide a broad range of cost-effective services. Our objective is to provide a variety of services in a broad continuum of care which will meet the ever changing needs of the elderly. Our expanded service offering currently includes skilled nursing, comprehensive rehabilitation services, programming for Life Steps and Lighthouse units, other specialty programming and medical supply and nutritional support services. By addressing varying levels of acuity, we work to meet the needs of the elderly population we serve for a longer period of time and to establish a reputation as the provider of choice in a particular market. Furthermore, we believe we are able to deliver quality services cost-effectively, thereby expanding the elderly population base that can benefit from our services, including those not otherwise able to afford private-pay assisted living services.
Increase occupancy through physical plant improvements and emphasis on marketing efforts. We believe we can increase occupancy in our nursing homes through improved physical plants and an increased emphasis on and an improved program for attracting and retaining patients and residents. We emphasize strong corporate and regional support for local facility based marketing efforts.
Improve quality of payor mix. We believe we can improve profitability by improving the payor mix of our patients. Quality payor sources include Medicare, HMO, managed care and private pay. These payor sources typically provide a better margin per revenue dollar or patient day.
Cluster operations on a regional basis. We have developed regional concentrations of operations in order to achieve operating efficiencies, generate economies of scale and capitalize on marketing opportunities created by having multiple operations in a regional market area.
Key elements of our growth strategy are to:
Increase revenues and profitability at existing facilities. Our strategy includes increasing center revenues and profitability levels through increasing occupancy levels, improving quality payor mix, maximizing reimbursement rates and containing costs. In addition to our facility renovation program, ongoing initiatives to promote higher occupancy levels and improved payor and case mixes at our nursing centers include programs to improve customer service, new contracts for insurance and other services, and units for specialized care services developed at certain centers.
Improve physical plants. Our nursing centers have an average age of approximately 30 years as of December 31, 2006. After a strategic review, Management determined that renovating certain facilities offered the opportunity to improve occupancy, quality of care and profitability. Management developed a plan to identify those facilities with the greatest potential for benefit, and began the renovation program during 2005. We have completed major renovations at four facilities and have renovations in progress at two facilities as of December 31, 2006. We expect to substantially complete two additional renovations in the first quarter of 2007, and plan to complete up to four more renovations in the third and fourth quarters of 2007. Major renovations result in significant cosmetic upgrades, including new flooring, wall coverings, lighting, ceilings and furniture throughout the facility. Renovations also usually include certain external work to improve curb appeal, such as concrete work, landscaping, roof, and signage enhancements.
Development of additional specialty services. Our strategy includes the development of additional specialty units and programming in facilities that could benefit from these services. The specialty programming will vary depending on the needs of the specific marketplace, and may include Life Steps and Lighthouse Units and other specialty programming. These services allow our facilities to improve census and payor mix. A center specific assessment of the market is conducted related to specialty programming to determine if unmet needs exist as a predictor of the success of particular niche offerings.
Acquisition, leasing and development of new homes. We continue to pursue and investigate opportunities to acquire, lease or develop new facilities, focusing primarily on opportunities within our existing areas of operation. We have entered into an option agreement to purchase certain assets of a skilled nursing facility in West Virginia. We have made an application to state regulatory authorities to allow us to operate the facility, and if successful, we intend to arrange financing and construct a new 90 bed replacement facility. The review of state regulators is expected to take from three to twelve months, and construction of the new facility is expected to take from eight to fourteen months.
Marketing.
At a local level, our sales and marketing efforts are designed to promote higher occupancy levels and optimal payor mix. We believe that the long-term care profession is fundamentally a local business in which both patients and residents and the referral sources for them are based in the immediate geographic area in which the facility is located. Our marketing plan and related support activities emphasize the role and performance of administrators, admissions coordinators and social services directors of each nursing center, all of whom are responsible for contacting various referral sources such as doctors, hospitals, hospital discharge planners, churches, and various community organizations.
Administrators are evaluated based on their ability to meet specific goals and performance standards that are tied to compensation incentives. Our regional managers and marketing coordinators assist local marketing personnel and administrators in establishing relationships and follow-up procedures with such referral sources.
In addition to soliciting admissions from these sources, we emphasize involvement in community affairs in order to promote a public awareness of our nursing centers and services. We have ongoing family councils and community based “family night” functions where organizations come to the facility to educate the public on various topics such as Medicare benefits, powers of attorney, and other matters of interest. We also promote effective customer relations and seek feedback through family surveys. We typically host “open house” events once we complete a major renovation of a facility where people in the community are invited to visit and see the improvements. In addition, we have regional marketing coordinators to support the overall marketing program in each local facility, in order to promote higher occupancy levels and improved payor and case mixes at our nursing centers.
We have an internally-developed marketing program that focuses on the identification and provision of services needed by the community. The program assists each facility administrator in analysis of local demographics and competition with a view toward complementary service development. We believe that the primary referral area in the long-term care industry generally lies within a five-to-fifteen-mile radius of each facility depending on population density; consequently, local marketing efforts are more beneficial than broad-based advertising techniques.
Divestitures.
We have undertaken several divestitures through sale of assets and lease terminations. The divested operations have generally been poor performing properties. In May 2006, we completed the sale of certain assets of eleven assisted facilities located in North Carolina for a sales price of $11.0 million. Proceeds from this transaction were used to pay transaction costs and repay debt. We closed one remaining North Carolina assisted living facility in April 2006, and are continuing our efforts to sell this facility and land.
We sold two nursing centers in Texas effective February 1, 2005. A lease covering three nursing centers in Texas expired in December 2004 and was not renewed. In November 2004, we sold certain assets of our medical supply business, Advocat Distribution Services. In May 2004, we sold the stock of our Canadian subsidiary, Diversicare Canada Management Services Co., Inc. (“DCMS”).
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” our consolidated financial statements have been reclassified to reflect these divestitures as discontinued operations.
Nursing Center Profession.
We believe there are a number of significant trends within the long term care industry that will support the continued growth of the nursing home segment of the long-term care industry. These trends are also likely to impact our business. These factors include:
Demographic trends. The primary market for our long-term health care services is comprised of persons aged 75 and older. This age group is one of the fastest growing segments of the United States population. As the number of persons aged 75 and over continues to grow, we believe that there will be corresponding increases in the number of persons who need skilled nursing.
Cost containment pressures. In response to rapidly rising health care costs, governmental and other third-party payors have adopted cost-containment measures to reduce admissions and encourage reduced lengths of stays in hospitals and other acute care settings. The federal
government had previously acted to curtail increases in health care costs under Medicare by limiting acute care hospital reimbursement for specific services to pre-established fixed amounts. Other third-party payors have begun to limit reimbursement for medical services in general to predetermined reasonable charges, and managed care organizations (such as health maintenance organizations) are attempting to limit hospitalization costs by negotiating for discounted rates for hospital and acute care services and by monitoring and reducing hospital use. In response, hospitals are discharging patients earlier and referring elderly patients, who may be too sick or frail to manage their lives without assistance, to nursing homes where the cost of providing care is typically lower than hospital care. In addition, third-party payors are increasingly becoming involved in determining the appropriate health care settings for their insureds or clients based primarily on cost and quality of care.
Limited supply of centers. As the nation’s elderly population continues to grow, life expectancy continues to expand, and there continue to be limitations on granting Certificates of Need (“CON’s”) for new skilled nursing centers, so we believe that there will be continued demand for skilled nursing beds in the markets in which we operate. The majority of states have adopted CON, or similar statutes, requiring that prior to adding new skilled beds or any new services, or making certain capital expenditures, a state agency must determine that a need exists for the new beds or proposed activities. We believe that this CON process tends to restrict the supply and availability of licensed skilled nursing center beds. High construction costs, limitations on state and federal government reimbursement for the full costs of construction, and start-up expenses also act to restrict growth in the supply for such centers. At the same time, skilled nursing center operators are continuing to focus on improving occupancy and expanding services to include high acuity subacute patients, who require significantly higher levels of skilled nursing personnel and care.
Reduced reliance on family care. Historically, the family has been the primary provider of care for seniors. We believe that the increase in the percentage of women in the work force, the reduction of average family size, and the increased mobility in society will reduce the role of the family as the traditional care-giver for aging parents. We believe that this trend will make it necessary for many seniors to look outside the family for assistance as they age.
Competition.
The long-term care business is highly competitive. We face direct competition for additional centers, and our centers face competition for employees, patients and residents. Some of our present and potential competitors for acquisitions are significantly larger and have or may obtain greater financial and marketing resources. Competing companies may offer new or more modern centers or new or different services that may be more attractive to patients, residents or facility owners than some of the services we offer.
The nursing centers operated by us compete with other facilities in their respective markets, including rehabilitation hospitals, other “skilled” and personal care residential facilities. In the few urban markets in which we operate, some of the long-term care providers with which our facilities compete are significantly larger and have or may obtain greater financial and marketing resources than our facilities. Some of these providers are not-for-profit organizations with access to sources of funds not available to our centers. Construction of new long-term care facilities near our existing centers could adversely affect our business. We believe that the most important competitive factors in the long-term care business are: a facility’s local reputation with referral sources, such as acute care hospitals, physicians, religious groups, other community organizations, managed care organizations, and a patient’s family and friends; physical plant condition; the ability to identify and meet particular care needs in the community; the availability of qualified personnel to provide the requisite care; and the rates charged for services. There is limited, if any, price competition with respect to Medicaid and Medicare patients, since revenues for services to such patients are strictly controlled and are based on fixed rates and cost reimbursement principles.
Although the degree of success with which our centers compete varies from location to location, we believe that our centers generally compete effectively with respect to these factors.
Payor Sources.
We classify our revenues from patients and residents into three major categories: Medicaid, Medicare and private pay. In addition to traditional Medicaid revenues, we include within the Medicaid classification revenues from other programs established to provide benefits to those in need of financial assistance in the securing of medical services. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. We classify payments from individuals who pay directly for services without government assistance as private pay revenue. The private pay classification also includes revenues from commercial insurers, HMOs, and other charge-based payment sources. Veterans Administration payments are included in private pay and are made pursuant to renewable contracts negotiated with these payors.
The following table sets forth net patient and resident revenues related to our continuing operations by payor source for the years presented:
The following table sets forth average daily census by payor source for our continuing operations for the years presented:
Consistent with the nursing home industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare, and private pay can significantly affect the profitability of the facility’s operations.
Reimbursement.
A significant portion of our revenues is derived from government-sponsored health insurance programs. Our nursing centers derive revenues under Medicaid, Medicare and private pay sources. We employ specialists in reimbursement at the corporate level to monitor regulatory developments, to comply with reporting requirements, and to ensure that proper payments are made to our operated nursing centers. It is generally recognized that all government-funded programs have been and will continue to be under cost containment pressures, but the extent to which these pressures will affect our future reimbursement is unknown.
The Balanced Budget Act enacted during 1997 (the “BBA”) phased in the prospective payment system for nursing centers and contained numerous Medicare and Medicaid cost-saving measures. As initially implemented, the BBA negatively impacted the entire long-term care industry. During 1999 and 2000,
certain amendments to the BBA were enacted, which helped restore some of the Medicare funding originally eliminated under the BBA. However, certain provisions in the amendments expired on September 30, 2002 and December 31, 2005.
In 2005, the Centers for Medicare and Medicaid Services (“CMS”) issued the final rule for the refinement of the Resource Utilization Group (“RUG”) system and provided for the elimination of the reimbursement add-ons for high acuity patients. In addition, Congress implemented a market basket adjustment of approximately 3.1% designed to increase reimbursement for the effects of inflation. The actual amount of the market basket adjustments is adjusted based on various factors. The market basket adjustment that became effective October 1, 2006 resulted in an average increase of approximately 2.1% for our facilities as a group, and increased our revenue by approximately $0.1 million per month.
Certain per person annual Medicare Part B reimbursement limits on therapy services became effective January 1, 2006. Subject to certain exceptions, the limits impose a $1,740 per patient annual ceiling on physical and speech therapy services, and a separate $1,740 per patient annual ceiling on occupational therapy services. CMS established an exception process to permit therapy services in certain situations, and the majority of services provided by us are reimbursed under the exceptions. On December 9, 2006, Congress passed the Tax Relief and Health Care Act of 2006 (TRHCA), which includes an extension of the existing exceptions process through December 31, 2007. If the exception process is discontinued after 2007, it is expected that the reimbursement limitations will reduce therapy revenues, and negatively impact our operating results and cash flows.
The Federal Deficit Reduction Act of 2005 mandates reducing by 30% the amount that Medicare reimburses nursing centers and other non-hospital providers for bad debts arising from uncollectible Medicare coinsurance and deductibles for those individuals that are not dually eligible for Medicare and Medicaid. The reduction is to be phased in over a three year period with 10% during fiscal 2006, 20% during fiscal 2007 and 30% thereafter. This provision is not expected to have a material impact on the Company.
The TRHCA passed by Congress on December 9, 2006 reduces the maximum federal matching under Medicare provider assessments to 5.5% of aggregate Medicaid outlays. This reduction in funding will become effective for fiscal years beginning after January 1, 2008. The Congressional action eliminated a regulatory effort proposed by the President’s proposed fiscal year 2007 federal budget to reduce the allowable federal matching share from 6% to 3%. The new law is expected to have an adverse effect in those states where the tax percentage exceeds 5.5%. The budget proposed by President Bush for the government’s 2007 fiscal year includes a number of proposed reductions to Medicare reimbursement for nursing homes and also appears to eliminate certain Federal matching programs that benefit many of the state Medicaid programs, including several of the states in which the Company operates. In the event the Federal government reduces the amount of state funding eligible for the Federal matching program, there will be pressure on the states to reduce current reimbursement levels. If the states reduce the Medicaid reimbursement in response to any Federal action, it is expected that the reduction in revenues would have a material effect on the Company’s operating results. The Company is unable to quantify the impact that these possible reimbursement cuts would have on it.
Reduction in health care spending has become a national priority in the United States, and the field of health care regulation and reimbursement is a rapidly evolving one. For the fiscal year ended December 31, 2006, we derived 30.5% and 56.5% of our total patient and resident revenues related to continuing operations from the Medicare and Medicaid programs, respectively. Any health care reforms that significantly limit rates of reimbursement under these programs could, therefore, have a material adverse effect on our profitability. We are unable to predict which reform proposals or reimbursement limitations will be adopted in the future, or the effect such changes would have on our operations.
We will attempt to increase revenues from non-governmental sources to the extent capital is available to do so, if at all. However, private payors, including managed care payors, are increasingly 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, which can result in significant losses to health care providers if patients require expensive treatment not adequately covered by the capitated rate.
Employees.
As of February 1, 2007, we employed a total of approximately 4,716 individuals in connection with our continuing operations. We believe that our employee relations are good. Approximately 151 of our employees are represented by a labor union.
Although we believe we are able to employ sufficient nurses and therapists to provide our services, a shortage of health care professional personnel in any of the geographic areas in which we operate could affect our ability to recruit and retain qualified employees and could increase our operating costs. We compete with other health care providers for both professional and non-professional employees and with non-health care providers for non-professional employees. This competition contributed to a significant increase in the salaries that we had to pay to hire and retain these employees.
Supplies and Equipment.
We purchase drugs, solutions and other materials and lease certain equipment required in connection with our business from many suppliers. We have not experienced, and do not anticipate that we will experience, any significant difficulty in purchasing supplies or leasing equipment from current suppliers. In the event that such suppliers are unable or fail to sell us supplies or lease equipment, we believe that other suppliers are available to adequately meet our needs at comparable prices. National purchasing contracts are in place for all major supplies, such as food, linens, and medical supplies. These contracts assist in maintaining quality, consistency and efficient pricing.
Government Regulation.
The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Over the last several years, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse statutes and regulations as well as laws and regulations governing quality of care issues in the skilled nursing profession in general. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations is subject to ongoing government review and interpretation, as well as regulatory actions in which government agencies seek to impose fines and penalties. The Company is involved in regulatory actions of this type from time to time. Additionally, changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, have had a material adverse effect on the industry and our consolidated financial position, results of operations, and cash flows. Future federal budget legislation and federal and state regulatory changes may further negatively impact us.
Licensure and Certification. All our nursing centers must be licensed by the state in which they are located in order to accept patients, regardless of payor source. In most states, nursing homes are subject to certificate of need laws, which require us to obtain government approval for the construction of new nursing homes or the addition of new licensed beds to existing homes. Our nursing centers must
comply with detailed statutory and regulatory requirements on an ongoing basis in order to qualify for licensure, as well as for certification as a provider eligible to receive payments from the Medicare and Medicaid programs. Generally, the requirements for licensure and Medicare/Medicaid certification are similar and relate to quality and adequacy of personnel, quality of medical care, record keeping, dietary services, resident rights, and the physical condition of the facility and the adequacy of the equipment used therein. Each facility is subject to periodic inspections, known as “surveys” by health care regulators, to determine compliance with all applicable licensure and certification standards. Such requirements are both subjective and subject to change. If the survey concludes that there are deficiencies in compliance, the facility is subject to various sanctions, including but not limited to monetary fines and penalties, suspension of new admissions, non-payment for new admissions and loss of licensure or certification. Generally, however, once a facility receives written notice of any compliance deficiencies, it may submit a written plan of correction and is given a reasonable opportunity to correct the deficiencies. There can be no assurance that, in the future, we will be able to maintain such licenses and certifications for our facilities or that we will not be required to expend significant sums in order to comply with regulatory requirements.
Medicare and Medicaid. Medicare is a federally-funded and administered health insurance program for the aged and for certain chronically disabled individuals. Part A of the Medicare program covers inpatient hospital services and certain services furnished by other institutional providers such as skilled nursing facilities. Part B covers the services of doctors, suppliers of medical items, various types of outpatient services, and certain ancillary services of the type provided by long term and acute care facilities. Medicare payments under Part A and Part B are subject to certain caps and limitations, as provided in Medicare regulations. Medicare benefits are not available for intermediate and custodial levels of nursing home care, or for assisted living facility arrangements.
Medicaid is a medical assistance program for the indigent, operated by individual states with financial participation by the federal government. Criteria for medical indigence and available Medicaid benefits and rates of payment vary somewhat from state to state, subject to certain federal requirements. Basic long-term care services are provided to Medicaid beneficiaries, including nursing, dietary, housekeeping and laundry and restorative health care services, room and board, and medications. Previously, under legislation known as the Boren Amendment, federal law required that Medicaid programs pay to nursing home providers amounts adequate to enable them to meet government quality and safety standards. However, the BBA repealed the Boren Amendment, and the BBA requires only that a state Medicaid program must provide for a public process for determination of Medicaid rates of payment for nursing facility services. Under this process, proposed rates, the methodologies underlying the establishment of such rates, and the justification for the proposed rates are published. This public process gives providers, beneficiaries and concerned state residents a reasonable opportunity for review and comment. Certain of the states in which we now operate are actively seeking ways to reduce Medicaid spending for nursing home care by such methods as capitated payments and substantial reductions in reimbursement rates.
HIPAA Compliance. The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) has mandated an extensive set of regulations to standardize electronic patient health, administrative and financial data transactions, and to protect the privacy of individually identifiable health information. We have a HIPAA Compliance Committee and designated privacy and security officers.
The HIPAA transaction standards are intended to simplify the electronic claims process and other healthcare transactions by encouraging electronic transmission rather than paper submission. These regulations provide for uniform standards for data reporting, formatting and coding that we must use in certain transactions with health plans. The HIPAA security regulations establish detailed requirements for safeguarding protected health information that is electronically transmitted or electronically stored. Some of the security regulations are technical in nature, while others are addressed through policies and procedures. We implemented or upgraded computer and information systems as we believed necessary to comply with the new regulations.
The HIPAA regulations related to privacy establish comprehensive federal standards relating to the use and disclosure of individually identifiable health information or protected health information. The privacy regulations establish limits on the use and disclosure of protected health information, provide for patients’ rights, including rights to access, request amendment of, and receive an accounting of certain disclosures of protected health information, and require certain safeguards for protected health information. In addition, each covered entity must contractually bind individuals and entities that furnish services to the covered entity or perform a function on its behalf, and to which the covered entity discloses protected health information, to restrictions on the use and disclosure of that information. In general, the privacy regulations do not supersede state laws that are more stringent or grant greater privacy rights to individuals. Thus, we must reconcile the privacy regulations and other state privacy laws.
Although we believe that we are in material compliance with these HIPAA regulations, the HIPAA regulations are expected to continue to impact us operationally and financially and may pose increased regulatory risk.
Self-Referral and Anti-Kickback Legislation. The health care industry is subject to state and federal laws which regulate the relationships of providers of health care services, physicians, and other clinicians. These self-referral laws impose restrictions on physician referrals to any entity with which they have a financial relationship, which is a broadly defined term. We believe our relationships with physicians are in compliance with the self-referral laws. Failure to comply with self-referral laws could subject us to a range of sanctions, including civil monetary penalties and possible exclusion from government reimbursement programs. There are also federal and state laws making it illegal to offer anyone anything of value in return for referral of patients. These laws, generally known as “anti-kickback” laws, are broad and subject to interpretations that are highly fact dependent. Given the lack of clarity of these laws, there can be no absolute assurance that any health care provider, including us, will not be found in violation of the anti-kickback laws in any given factual situation. Strict sanctions, including fines and penalties, exclusion from the Medicare and Medicaid programs and criminal penalties, may be imposed for violation of the anti-kickback laws.
Available Information.
We file reports with the Securities and Exchange Commission (“SEC”), including annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K. Copies of our reports filed with the SEC may be obtained by the public at the SEC’s Public Reference Room by calling the SEC at 1-800-SEC-0330. We file such reports with the SEC electronically, and the SEC maintains an Internet site at www.sec.gov that contains our reports, proxy and information statements, and other information filed electronically. We also make available, free of charge through our website, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and other materials filed with the SEC as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. Our website address is www.irinfo.com/AVC. The information provided on our website is not part of this report, and is therefore not incorporated by reference unless such information is otherwise specifically referenced elsewhere in this report.
ITEM 1A.
ITEM 1A. RISK FACTORS
There have been a number of material developments both within the Company and the long-term care industry. These developments have had and are likely to continue to have a material impact on us. This section summarizes these developments, as well as other risks, that should be considered by our shareholders and prospective investors.
We are substantially self-insured and have significant potential professional liability exposure.
The provision of health care services entails an inherent risk of liability. Participants in the health care industry are subject to an increasing number of lawsuits alleging malpractice, product liability, or related legal theories, many of which involve large claims and significant defense costs. The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence in providing care to its patients and we are no exception in this regard. We have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. We expect to continue to be subject to such suits as a result of the nature of our business. See “Item 3. Legal Proceedings.” for further descriptions of pending claims, and see “Item 7. Management’s Discussion and Analysis of Financial Condition - Accounting Policies and Judgments - Professional Liability and Other Self-Insurance Reserves.” for discussion of our reserve for self-insured claims and of our ability to meet our anticipated cash needs.
Due to our past claims experience and increasing cost of claims throughout the long-term care industry, the premiums we pay for professional liability and other liability insurance to cover future periods exceeds the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, we have purchased professional liability insurance coverage for our facilities that, based on historical claims experience, is likely to be substantially less than the claims we expect to incur. We have exhausted all of our insurance coverage for claims asserted prior to March 7, 2007. For claims made during the period from March 10, 2007 through March 9, 2008, the Company maintains insurance with coverage limits of $100,000 per medical incident and total aggregate policy coverage limits of $500,000. As a result, we are effectively self-insured and expect to remain so for the foreseeable future.
We have significant deferred tax assets which we may not be able to realize.
We have net deferred tax assets of $23.6 million included in our balance sheet as of December 31, 2006. Our ability to realize these deferred tax assets depends on our future taxable income. We reported taxable income for 2004 and 2005. The sale of certain assets during 2006 will result in a taxable loss when our tax returns are filed. We expect future operations will continue to result in taxable income that will allow these deferred tax assets to be realized. During 2006 we reversed $14.6 million in valuation allowances on our deferred tax assets in anticipation that we will realize a larger portion of these assets based on our achieved earnings trend and outlook. However, no assurance can be given that we will be able to generate taxable income in future periods or realize these deferred tax assets.
We have had substantial downward adjustments to our accrual for professional liability claims which has caused significant increases in our net earnings.
In the years ended December 31, 2006, 2005 and 2004, we recorded downward adjustments in our accrual for self-insured risks associated with professional liability claims. While these adjustments to the accrual resulted in reported income, they did not generate cash because the accrual is not funded. These self-insurance reserves are assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period. Our actual liabilities may vary significantly from the accrual, and the amount of the accrual has and may continue to fluctuate by a material amount in any given quarter. Each change in the amount of this accrual will directly affect our reported earnings and financial position for the period in which the change in accrual is made. No assurance can be given that the accrual will decline during 2007, and it may increase during this period.
A substantial portion of our outstanding indebtedness is subject to floating rates of interest which could be subject to fluctuations based on changing interest rates.
We have $31.5 million of indebtedness at December 31, 2006, with $7.2 million classified as a current liability at December 31, 2006 based on payment terms. Approximately 92% of our indebtedness consists of floating rate debt, which is at variable rates of interest and exposes us to interest rate risk. Interest rate risk is the risk of loss arising from adverse changes in interest rates associated with variable rate borrowings. If interest rates increase, there is potential that our debt service obligations would increase even though the amount borrowed would decrease or remain the same. In addition, certain of our debt agreements contain various financial covenants, the most restrictive of which relate to cash flow, net income (loss), liquidity and limits on the payment of dividends to shareholders. As of December 31, 2006, we were in compliance with these financial covenants. Our failure to comply with those covenants could result in an event of default, which, if not cured or waived, could result in the acceleration of some or all of our debts. Such non-compliance could result in a material adverse impact to our financial position, results of operations and cash flows. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Financial Resources.”
We are highly dependent on reimbursement by third-party payors.
Substantially all of our nursing center revenues are directly or indirectly dependent upon reimbursement from third-party payors, including the Medicare and Medicaid programs, and private insurers. For the year ended December 31, 2006, our patient revenues from continuing operations derived from Medicaid, Medicare and private pay (including private insurers) sources were approximately 56.5%, 30.5%, and 13.0%, respectively. Changes in the mix of our patients among Medicare, Medicaid and private pay categories and among different types of private pay sources may affect our net revenues and profitability. Our net revenues and profitability are also affected by the continuing efforts of all payors to contain or reduce the costs of health care. Efforts to impose reduced payments, greater discounts and more stringent cost controls by government and other payors are expected to continue.
The federal Government makes frequent changes to the reimbursement provided under the Medicare program. These changes could reduce significantly the reimbursement we receive. Also, a number of state governments, including several of the states in which we operate, have announced projected budget shortfalls and/or deficit spending situations. In addition, the President’s proposed budget calls for a significant reduction in the amount of Federal funds provided to the state Medicaid systems. Possible actions by these states include reductions of Medicaid reimbursement to providers such as us or the failure to increase Medicaid reimbursements to cover increased operating costs.
Any changes in reimbursement levels or in the timing of payments under Medicare, Medicaid or private pay programs and any changes in applicable government regulations could have a material adverse effect on our net revenues, net income and cash flows. We are unable to predict what reform proposals or reimbursement limitations will be adopted in the future or the effect such changes will have on our operations. No assurance can be given that such reforms will not have a material adverse effect on us. See “Item 1. Business - Government Regulation and Reimbursement.”
We are subject to significant government regulation.
The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Various federal and state laws regulate relationships among providers of services, including employment or service contracts and investment relationships. The operation of long-term care centers and the provision of services are also subject to extensive federal, state, and local laws relating to, among other things, the adequacy of medical care, distribution of pharmaceuticals, equipment, personnel, operating policies,
environmental compliance, compliance with the Americans with Disabilities Act, fire prevention and compliance with building codes.
Long-term care facilities are also subject to periodic inspection to assure continued compliance with various standards and licensing requirements under state law, as well as with Medicare and Medicaid conditions of participation. The failure to obtain or renew any required regulatory approvals or licenses could adversely affect our growth and could prevent us from offering our existing or additional services. In addition, health care is an area of extensive and frequent regulatory change. Changes in the laws or new interpretations of existing laws can have a significant effect on methods and costs of doing business and amounts of payments received from governmental and other payors. Our operations could be adversely affected by, among other things, regulatory developments such as mandatory increases in the scope and quality of care to be afforded patients and revisions in licensing and certification standards. We attempt at all times to comply with all applicable laws; however, there can be no assurance that new legislation or administrative or judicial interpretation of existing laws or regulations will not have a material adverse effect on our operations or financial condition. Changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, have had a material adverse effect on the profession and our consolidated financial position, results of operations, and cash flows. Future federal budget legislation, federal or state regulatory actions seeking to impose fines and penalties, and federal and state regulatory changes may negatively impact us. See “Item 1. Business - Government Regulation.” See also “Item 3, Legal Proceedings.”
The health care industry has been the subject of increased regulatory scrutiny recently.
The Office of Inspector General (“OIG”), the enforcement arm of the Medicare program, formulates a formal work plan each year for nursing homes. The OIG’s most recent work plan indicates that access to care, quality of care, survey deficiencies, compliance with minimum data set reporting, resident assessment and care planning, and the medical necessity of services billed will be an investigative focus in 2007. We cannot predict the likelihood, scope or outcome of any such investigations on our facilities.
We are subject to claims under the self-referral and anti-kickback legislation.
In the United States, various state and federal laws regulate the relationships between providers of health care services, physicians, and other clinicians. These self-referral laws impose restrictions on physician referrals for designated health services to entities with which they have financial relationships. These laws also prohibit the offering, payment, solicitation or receipt of any form of remuneration in return for the referral of Medicare or state health care program patients or patient care opportunities for the purchase, lease or order of any item or service that is covered by the Medicare and Medicaid programs. To the extent that we, any of our facilities with which we do business, or any of the owners or directors have a financial relationship with each other or with other health care entities providing services to long-term care patients, such relationships could be subject to increased scrutiny. There can be no assurance that our operations will not be subject to review, scrutiny, penalties or enforcement actions under these laws, or that these laws will not change in the future. Violations of these laws may result in substantial civil or criminal penalties for individuals or entities, including large civil monetary penalties and exclusion from participation in the Medicare or Medicaid programs. Such exclusion or penalties, if applied to us, could have a material adverse effect on our profitability.
We operate in an industry that is highly competitive.
The long-term care industry generally, and the nursing home business particularly, is highly competitive. We face direct competition for the acquisition of facilities. In turn, our facilities face competition for employees, patients and residents. Some of our present and potential competitors are significantly larger and have or may obtain greater financial and marketing resources than we can. Some hospitals that provide long-term care services are also a potential source of competition. In addition, we may encounter
substantial competition from new market entrants. Consequently, there can be no assurance that we will not encounter increased competition in the future, which could limit our ability to attract patients or residents or expand our business, and could materially and adversely affect our business or decrease our market share.
We have a number of policies in place that could be considered anti-takeover protections.
We have adopted a Shareholder Rights Plan (the “Plan”). In March 2005, the Board of Directors amended the Plan to extend the expiration date of the Plan to March 20, 2010 and change the exercise price of the rights under the Plan to $15. The Plan is intended to encourage potential acquirers to negotiate with our Board of Directors and to discourage coercive, discriminatory and unfair proposals. Our Certificate of Incorporation (the “Certificate”) provides for the classification of our Board of Directors into three classes, with each class of directors serving staggered terms of three years. Our Certificate requires the approval of two-thirds of the outstanding shares to amend certain provisions of the Certificate. Section 203 of the Delaware General Corporate Law restricts the ability of a Delaware corporation to engage in any business combination with an interested shareholder. We are also authorized to issue up to 795,000 shares of preferred stock, the rights of which may be fixed by the Board of Directors without shareholder approval. Provisions in certain of our executive officers’ employment agreements provide for post-termination compensation, including payment of amounts up to 2.5 times their annual salary, following certain changes in control. Our stock incentive plans provide for the acceleration of the vesting of options in the event of certain changes in control (as defined in such plans). Certain changes in control also constitute an event of default under our bank credit facility. The foregoing matters may, together or separately, have the effect of discouraging or making more difficult an acquisition or change of control of us.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
We own 9 and lease 34 long-term care facilities. A description of our lease agreements follows.
Description of Lease Agreements.
Our current operations include 34 nursing centers subject to operating leases, including 33 owned or financed by Omega Healthcare Investors, Inc. (“Omega”) and one owned by another party. In our role as lessee, we are responsible for the day-to-day operations of all operated centers. These responsibilities include recruiting, hiring, and training all nursing and other personnel, and providing resident care, nutrition services, marketing, quality improvement, accounting, and data processing services for each facility. The lease agreements pertaining to our 34 leased facilities are “triple net” leases, requiring us to maintain the premises, pay taxes and pay for all utilities. The leases typically provide for an initial term of 4 to 10 years with renewal options up to 12 years. The average remaining term of our lease agreements, including renewal options, is approximately 21 years.
Omega Master Lease. We lease 29 nursing centers from Omega pursuant to one lease agreement dated October 1, 2000 (the “Omega Master Lease”). All of the accounts receivable, equipment, inventory and other assets of the facilities leased have been pledged as security under the Omega Master Lease. The initial term of the Omega Master Lease was ten years, expiring September 30, 2010.
On October 20, 2006 we entered into a Third Amendment to Consolidated Amended and Restated Master Lease (“Lease Amendment”) with Omega to extend the term of the Omega Master Lease. The amended master lease commenced on October 1, 2006, and extends to September 30, 2018. The Lease Amendment also provides for a renewal option of an additional twelve years, assuming no defaults. Consistent with prior terms, the lease provides for annual increases in lease payments equal to the lesser of two times the increase in the consumer price index or 3.0%.
Lease payments were $12.9 million for the year ended December 31, 2006. The Omega Master Lease requires us to fund annual capital expenditures equal to $325 per licensed bed, subject to adjustment for increases in the Consumer Price Index (annual required capital expenditures of $0.7 million in 2007). Upon expiration of, or in the event of a default under the Omega Master Lease, we are required to transfer all of the leasehold improvements, equipment, furniture and fixtures of the leased facilities to Omega.
The 2006 Lease Amendment together with an earlier amendment in 2005 provide for additional financing of up to $10 million to be used to fund renovations to several nursing centers leased from Omega. The renovations will be completed before June 30, 2008. The annual base rent related to these facilities will be increased to reflect the amount of capital improvements made to the respective facilities. The amendments also included provisions to amend certain professional liability insurance requirements in order to cure certain defaults under the Omega Master Lease.
The Omega Master Lease prohibits us from operating any additional facilities within a certain radius of each leased facility. We are generally required to maintain comprehensive insurance covering the facilities we lease as well as personal and real property damage insurance and professional liability insurance. The failure to pay rentals within a specified period or to comply with the required operating and financial covenants, including insurance coverage, generally constitutes a default, which default, if uncured, permits Omega to terminate the lease and assume the property and the contents within the facilities.
Florida Leases. Effective April 1, 2003, we entered into leases for four nursing centers in Florida that had previously been managed by us under management contracts. Accordingly, the results of operations of these facilities are included in our results of operations beginning April 1, 2003. Omega holds mortgages on these properties and we make the lease payments directly to Omega. In December 2005, we extended the term of the leases through February 2010. Lease payments will be $1.6 million during 2007, with increases equal to the lesser of two times the consumer price index or 3.0% in subsequent years. We are also required to fund annual capital expenditures equal to $350 per licensed bed over the initial lease term, subject to adjustment for increases in the Consumer Price Index.
Other Leases. We lease approximately 25,000 square feet of office space in Brentwood, Tennessee, that houses our executive offices, centralized management support functions, and the ancillary services supply operations. In addition, we lease our regional office with approximately 4,000 square feet of office space in Ashland, Kentucky. Lease periods on these facilities generally range up to seven years. Regional executives for Alabama, Arkansas, Florida, Tennessee and Texas work from offices of up to 1,500 square feet each. We believe that our leased properties are adequate for our present needs and that suitable additional or replacement space will be available as required.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The provision of health care services entails an inherent risk of liability. Participants in the health care industry are subject to an increasing number of lawsuits alleging malpractice, product liability, or related legal theories, many of which involve large claims and significant defense costs. The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence in providing care to its patients and we are no exception in this regard. We have numerous
pending liability claims, disputes and legal actions for professional liability and other related issues. It is expected that we will continue to be subject to such suits as a result of the nature of our business. Further, as with all health care providers, we are periodically subject to regulatory actions seeking fines and penalties for alleged violations of health care laws and are potentially subject to the increased scrutiny of regulators for issues related to compliance with health care fraud and abuse laws.
As of December 31, 2006, we are engaged in 18 professional liability lawsuits. Three of these matters are currently scheduled for trial within the next year. The ultimate results of any of our professional liability claims and disputes cannot be predicted. We have limited, and sometimes no, professional liability insurance with regard to most of these claims. A significant judgment entered against us in one or more of these legal actions could have a material adverse impact on our financial position and cash flows.
We cannot currently predict with certainty the ultimate impact of any of the above cases on our financial condition, cash flows or results of operations. An unfavorable outcome in any of the lawsuits, any regulatory action, any investigation or lawsuit alleging violations of fraud and abuse laws or of elderly abuse laws or any state or Federal False Claims Act case could have a material adverse impact on our financial condition, cash flows or results of operations and could also subject us to fines, penalties and damages. Moreover, we could be excluded from the Medicare, Medicaid or other state or federally-funded health care programs, which would also have a material adverse impact on our financial condition, cash flows or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter (October 1, 2006 through December 31, 2006) of the fiscal year covered by this Annual Report on Form 10-K.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our Common Stock was listed on the New York Stock Exchange under the symbol “AVC” through November 9, 1999. From that time through September 11, 2006, our Common Stock was traded on NASD’s OTC Bulletin Board under the symbol “AVCA.” During the third quarter of 2006, our common stock shares were approved for listing on the NASDAQ Capital Market and began trading there on September 12, 2006 under the symbol “AVCA.” The following table sets forth the high and low bid prices of the common stock for each quarter in 2005 and 2006:
Our Common Stock has been traded since May 10, 1994. On March 2, 2007, the closing price for our Common Stock was $12.20, as reported by NASDAQ.com.
On March 2, 2007, there were approximately 286 holders of record of the Common Stock. Most of our shareholders have their holdings in the street name of their broker/dealer.
We have not paid cash dividends on our Common Stock and anticipate that, for the foreseeable future, any earnings will be retained for use in our business and no cash dividends will be paid. We are currently prohibited from issuing dividends under certain of our debt instruments.
We made no purchases of our stock during the fourth quarter of the year ended December 31, 2006.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected financial data of Advocat presented in the following table have been derived from our financial statements, and should be read in conjunction with the annual financial statements and related Notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations. This selected financial data for all periods shown have been reclassified to present the effects of certain divestitures as discontinued operations.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
Advocat Inc. provides long-term care services to nursing center patients in eight states, primarily in the Southeast. Our centers provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care centers, we offer a variety of comprehensive rehabilitation services as well as nutritional support services.
As of December 31, 2006, our continuing operations consist of 43 nursing centers with 4,505 licensed nursing beds and 66 assisted living units. As of December 31, 2006, our continuing operations include nine owned nursing centers and 34 leased nursing centers.
Divestitures. We have undertaken several divestitures through sale of assets and lease terminations. The divested operations have generally been poor performing properties. In May 2006, we completed the sale of certain assets of eleven assisted living facilities located in North Carolina for a sales price of $11.0 million. We closed one remaining North Carolina assisted living facility in April 2006, and are continuing our efforts to sell this facility and land. In February 2005, we sold two nursing centers in Texas. A lease covering three nursing centers in Texas expired in December 2004 and was not renewed. In November 2004, we sold certain assets of our medical supply business, Advocat Distribution Services. In May 2004, we sold the stock of our Canadian subsidiary, Diversicare Canada Management Services Co., Inc. (“DCMS”).
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” our consolidated financial statements have been reclassified to reflect these divestitures as discontinued operations.
Basis of Financial Statements. Our patient revenues consist of the fees charged for the care of patients in the nursing centers we own and lease. Our operating expenses include the costs, other than lease, depreciation and amortization expenses, incurred in the operation of the nursing centers we owned and leased. Our general and administrative expenses consist of the costs of the corporate office and regional support functions. Our depreciation and interest expenses include all such expenses across the range of our operations.
Selected Financial and Operating Data
The following table summarizes the Advocat statements of continuing operations for the years ended December 31, 2006, 2005 and 2004, and sets forth this data as a percentage of revenues for the same years.
The following table presents data about the facilities we operated as part of our continuing operations as of the dates or for the years indicated:
Critical Accounting Policies and Judgments
A “critical accounting policy” is one which is both important to the understanding of our financial condition and results of operations and requires management’s most difficult, subjective or complex judgments often of the need to make estimates about the effect of matters that are inherently uncertain. Our accounting policies that fit this definition include the following:
Revenues
Patient Revenues
The fees we charge patients in our nursing centers are recorded on an accrual basis. These rates are contractually adjusted with respect to individuals receiving benefits under federal and state-funded programs and other third-party payors. Rates under federal and state-funded programs are determined prospectively for each facility and may be based on the acuity of the care and services provided. These rates may be based on facility’s actual costs subject to program ceilings and other limitations or on established rates based on acuity and services provided as determined by the federal and state-funded programs. Amounts earned under federal and state programs with respect to nursing home patients are subject to review by the third-party payors which may result in retroactive adjustments. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. Retroactive adjustments, if any, are recorded when objectively determinable, generally within three years of the close of a reimbursement year depending upon the timing of appeals and third-party settlement reviews or audits.
Allowance for Doubtful Accounts
Our allowance for doubtful accounts is estimated utilizing current agings of accounts receivable, historical collections data and other factors. We monitor these factors and determine the estimated provision for doubtful accounts. Historical bad debts have generally resulted from uncollectible private balances, some uncollectible coinsurance and deductibles and other factors. Receivables that are deemed to be uncollectible are written off. The allowance for doubtful accounts balance is assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified.
Professional Liability and Other Self-Insurance Reserves
Self-insurance reserves primarily represent the accrual for self-insured risks associated with general and professional liability claims, employee health insurance and workers compensation. Our health insurance reserve is based on known claims incurred and an estimate of incurred but unreported claims determined by an analysis of historical claims paid. Our workers compensation reserve relates primarily to periods of self insurance prior to May 1997 and consists of an estimate of the future costs to be incurred for the known claims. Expected insurance coverages are reflected as a reduction of the reserves. All of our self-insurance reserves are assessed and adjusted on a quarterly basis.
Accrual for Professional and General Liability Claims-
Because our actual liability for existing and anticipated professional liability and general liability claims will exceed our limited insurance coverage, we have recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $25.7 million as of December 31, 2006. This accrual includes estimates of liability for incurred but not reported claims, estimates of liability for reported but unresolved claims, actual liabilities related to settlements, including settlements to be paid over time, and estimates of related legal costs incurred and expected to be incurred. All losses are projected on an undiscounted basis.
We retain a third-party actuarial firm to estimate the appropriate accrual for incurred general and professional liability claims. For current periods, the actuary primarily uses historical data regarding the frequency and cost of our past claims over a multi-year period and information regarding our number of occupied beds to develop its estimates of our ultimate professional liability cost for current periods. The actuary estimates our professional liability accrual for past periods by using currently-known information to adjust the initial reserve that was created for that period.
On a quarterly basis, we obtain reports of claims and lawsuits that we have incurred from insurers and a third party claims administrator. These reports contain information relevant to the liability actually incurred to date with that claim as well as the third-party administrator’s estimate of the anticipated total cost of the claim. This information is reviewed by us and provided to the actuary. The actuary uses this information to determine the timing of claims reporting and the development of reserves, and compares the information obtained to its original estimates of liability. Based on the actual claim information obtained and on estimates regarding the number and cost of additional claims anticipated in the future, the reserve estimate for a particular prior period may be revised upward or downward on a quarterly basis. Final determination of our actual liability for claims incurred in any given period is a process that takes years. The following summarizes our accrual for professional liability and other claims for each policy year as of the end of the period:
Although we retain a third-party actuarial firm to assist us, professional and general liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. As a result, our actual liabilities may vary significantly from the accrual, and the amount of the accrual has and may continue to fluctuate by a material amount in any given quarter. Many factors could result in differences between amounts estimated and the ultimate amount of our loss for any period. One of the key assumptions in the actuarial analysis is that historical losses provide an accurate forecast of future losses. This assumption may not prove accurate, as changes in legislation such as tort reform, changes in our financial condition, changes in our risk management practices and other factors may affect the severity and frequency of claims incurred in future periods as compared to historical claims. Another key assumption is the limit of claims to a maximum of $4.5 million. The actuary has selected this limit based on our historical data. While most of our claims have been for amounts less than the $4.5 million, there have been claims at higher amounts, and there may be claims above this level in the future. The facts and circumstances of each claim vary significantly, and the amount of ultimate liability for an individual claim may vary due to many factors, including whether the case can be settled by agreement, the quality of legal representation, the individual jurisdiction in which the claim is pending, and the views of the particular judge or jury deciding the case. To date, we have not experienced an uninsured loss in excess of this limit. In the event that we believe we have incurred a loss in excess of this limit, an adjustment to the reserves determined by the actuary would be necessary.
We believe that the use of actuarial methods described above provides a valid and reasonable method to estimate our liability for professional and general liability claims and that the expertise of a third- party actuary is required to estimate liabilities using this methodology.
Each quarter, we record in our consolidated statement of operations for that period the estimated accrual for anticipated liability claims incurred in that period as well as any revisions in estimates and differences between actual settlements and accruals for prior periods. While each quarterly adjustment to the recorded liability for professional liability claims affects reported income, these changes do not directly affect our cash position because the accrual for these liabilities is not funded. A significant judgment entered against us in one or more of these legal actions could have a material adverse impact on our financial position and cash flows.
Professional liability costs are material to our financial position, and differences between estimates and the ultimate amount of loss may cause a material fluctuation in our reported results of operations. The liability recorded at December 31, 2006, was $25.7 million, compared to current assets of $37.8 million and total assets of $96.9 million. For the years ended December 31, 2006, 2005 and 2004, our professional liability expense was negative $4.8 million, negative $4.0 million and negative $1.8 million, respectively, with negative amounts representing net benefits resulting from downward revisions in previous estimates. These amounts are material in relation to our reported net income from continuing operations for the related periods of $21.9 million, $30.6 million and $12.5 million, respectively.
Accrual for Other Self-Insured Claims-
With respect to workers’ compensation insurance, substantially all of our employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. We are completely self-insured for workers compensation exposures prior to May 1997. We have been and remain a non-subscriber to the Texas workers’ compensation system and are, therefore, completely self-insured for employee injuries with respect to our Texas operations. We have provided reserves for the settlement of outstanding self-insured claims at amounts believed to be adequate. The liability we recorded for the self-insured obligations under these plans is $0.5 million as of December 31, 2006.
Effective June 30, 2003, we entered into workers compensation insurance programs that provide coverage for claims incurred, with premium adjustments depending on incurred losses. We account for premium expense under these policies based on our estimate of the level of claims expected to be incurred. As of December 31, 2006, we have recorded estimated premium refunds due under these programs totaling approximately $3.5 million, included in “insurance refunds receivable” in the accompanying balance sheet. Any adjustments of future premiums for workers compensation policies and differences between actual settlements and reserves for self-insured obligations are included in expense in the period finalized.
We are self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 per individual annually. We provide reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate. The liability for reported claims and estimates for incurred but unreported claims is $0.9 million at December 31, 2006. The differences between actual settlements and reserves are included in expense in the period finalized.
Asset Impairment
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we evaluate the recoverability of the carrying values of our properties on a property by property basis. On a quarterly basis, we review our properties for recoverability when events or circumstances, including significant physical changes in the property, significant adverse changes in general economic conditions, and significant deteriorations of the underlying cash flows of the property, indicate that the carrying amount of the property may not be recoverable. The need to recognize an impairment is based on estimated future cash flows from a property compared to the carrying value of that property. If recognition of an impairment is necessary, it is measured as the amount by which the carrying amount of the property exceeds the fair value of the property.
Stock-Based Compensation
Beginning January 1, 2006, we adopted SFAS No. 123R, “Share-Based Payment,” using the modified prospective method, in which we recognize compensation cost for all share-based payments granted after the effective date. We recorded stock-based compensation expense and estimated our unrecognized stock-based compensation that we will recognize on a straight-line basis over the remaining vesting period. We calculated the recognized and unrecognized stock-based compensation using the Black-Scholes-Merton option valuation method, which requires us to use certain key assumptions to develop the fair value estimates. These key assumptions include expected volatility, risk-free interest rate, expected dividends and expected term.
Income Taxes
We follow SFAS No. 109, “Accounting for Income Taxes,” which requires an asset and liability approach for financial accounting and reporting of income taxes. Under this method, deferred tax assets and liabilities are determined based upon differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax laws that will be in effect when the differences are expected to reverse. We assess the need for a valuation allowance to reduce the deferred tax assets by the amount we believe is more likely not to be utilized through the turnaround of existing temporary differences, future earnings, or a combination thereof, including certain net operating loss carryforwards we do not expect to realize due to change in ownership limitations.
Contractual Obligations and Commercial Commitments
We have certain contractual obligations of continuing operations as of December 31, 2006, summarized by the period in which payment is due, as follows (dollar amounts in thousands):
(1)
Long-term and short-term debt obligations include scheduled future payments of principal and interest of long-term and short-term debt.
(2)
Settlement promissory note obligations include principal and interest of long-term debt.
(3)
Series C Preferred Stock includes quarterly dividend payments and redemption value at preferred shareholder’s earliest redemption date.
(4)
Payments for the elimination of preferred stock conversion feature - See “Liquidity and Capital Resources.”
(5)
Includes annual expenditure requirements for capital maintenance under mortgage loan covenants as well as $0.6 million for planned facility renovation in accordance with loan agreement.
(6)
Includes annual capital expenditure requirements under operating leases.
We have employment agreements with certain members of management that provide for the payment to these members of amounts up to 2.5 times their annual salary in the event of a termination without cause, a constructive discharge (as defined), or upon a change of control of the Company (as defined). The maximum contingent liability under these agreements is approximately $1.8 million. The terms of such agreements are from one to three years and automatically renew for one year if not terminated by us or the employee. In addition, upon the occurrence of any triggering event, certain executives may elect to require that we purchase options granted to them for a purchase price equal to the difference in the fair market value of our common stock at the date of termination versus the stated option exercise price. Based on the closing price of our stock on December 31, 2006, the maximum contingent liability for the repurchase of the currently vested options is approximately $2.9 million. No amounts have been accrued for this contingent liability.
Asset Impairment and Other Charges
In 2005 and 2004, we recorded asset impairment and other charges as shown below. No asset impairment charges were recorded in 2006.
In 2005 and 2004, we recorded asset impairment charges of $4,397,000 and $8,419,000, respectively, for the impairment of certain long-lived assets in accordance with the provisions of SFAS 144. A detail of the impaired asset charges is as follows:
We terminated facility leases for three nursing centers in 2004. We incurred lease termination charges of approximately $341,000 in 2004 consisting of the remaining net book value of these facilities, costs of completing the transactions and settlement charges.
Payor Sources.
We classify our revenues from patients and residents into three major categories: Medicaid, Medicare and private pay. In addition to traditional Medicaid revenues, we include within the Medicaid classification revenues from other programs established to provide benefits to those in need of financial assistance in the securing of medical services. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. We classify payments from individuals who pay directly for services without government assistance as private pay revenue. The private pay classification also includes revenues from commercial insurers, HMOs, and other charge-based payment sources. Veterans Administration payments are included in private pay and are made pursuant to renewable contracts negotiated with these payors.
Medicare represented approximately 30.5%, 30.0%, and 29.3% of our net revenues during 2006, 2005, and 2004, respectively. Approximately 56.5%, 58.0%, and 59.4% of our net revenues were derived from Medicaid during 2006, 2005, and 2004, respectively. Private pay represented approximately 13.0%, 12.0% and 11.3% of our net revenues during 2006, 2005, and 2004, respectively.
Consistent with the nursing home industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare, and private pay can significantly affect the profitability of the facility’s operations.
Results of Operations
The following tables present interim statements of operations and related data for the years ended December 31, 2006, 2005 and 2004:
Year Ended December 31, 2006 Compared With Year Ended December 31, 2005
In 2005 and 2006, we entered into several divestiture transactions, and our consolidated financial statements have been reclassified to present such transactions as discontinued operations. Accordingly, the related revenue, expenses, assets, liabilities and cash flows have been reported separately, and the discussion below addresses principally the results of our continuing operations.
Patient revenues. Patient revenues increased to $216.8 million in 2006 from $203.7 million in 2005, an increase of $13.1 million, or 6.4%. The increase in revenues is due to increased Medicaid rates in certain states, increased Medicare utilization, Medicare rate increases and an increase in census in 2006 as compared to 2005. The average rate of occupancy at our nursing centers increased to 77.9% in 2006 from 76.2% in 2005. As a percentage of total census, Medicare days increased to 13.8% in 2006 from 13.0% in 2005. Medicare revenues were 30.5% of revenue in 2006 and 30.0% in 2005, while Medicaid and similar programs were 56.5% in 2006 compared to 58.0% in 2005.
Our average rate per day for Medicare Part A patients increased to $323.97 in 2006 from $311.48 in 2005, an increase of 4.0%. We previously expected that our rate would decrease from the 2005 level due to the Medicare RUG refinements that were implemented effective January 1, 2006. The acuity levels of Medicare patients in our nursing centers were higher than expected with a resulting increase in the average Medicare rate per patient day. Our average rate per day for Medicaid patients increased to $133.74 in 2006 from $128.71 in 2005, an increase of 3.9%.
Operating expense. Operating expense increased to $165.3 million in 2006 from $155.5 million in 2005, an increase of $9.8 million, or 6.3%. As a percentage of revenues, operating expenses were 76.3% in 2006, compared to 76.4% in 2005. The increase in operating expense is primarily attributable to cost increases related to wages and benefits, partially offset by a reduction in expense related to workers compensation insurance expense. The decrease in operating costs as a percentage of patient and resident revenues is primarily due to the effects of increases in Medicare and Medicaid rates and increased Medicare utilization, as discussed above.
The largest component of operating expenses is wages, which increased to $98.8 million in 2006 from $92.0 million in 2005, an increase of $6.8 million, or 7.4%. This increase is primarily attributable to an increase in wages as a result of increased costs of nursing care associated with the higher Medicare census, competitive labor markets in most of the areas in which we operate, and regular merit and inflationary raises for personnel.
Employee health insurance costs were approximately $0.7 million higher in 2006 compared to 2005, an increase of approximately 18.6%. The Company is self insured for the first $150,000 in claims per employee each year. Employee health insurance costs can vary significantly from year to year.
Costs of workers compensation insurance were approximately $1.4 million lower in 2006 compared to 2005. Beginning with the policy year that started in July 2005, our workers compensation insurance policies provided us with greater premium decreases resulting from reductions in claims experience. We have had better than expected claims experience, allowing us to reduce the cost of workers compensation insurance.
The remaining increases in operating expense are primarily due to the effects of increases in total census and Medicare utilization.
Lease expense. Lease expense increased to $16.1 million in 2006 from $15.8 million in 2005, an increase of $0.3 million, or 1.6%. Effective October 1, 2006, we renewed a master lease covering 29 nursing centers. This resulted in an increase in lease expense of $0.7 million during 2006 for the effects of recording scheduled rent increases on a straight-line basis over the term of the renewal period, and will result in increased lease expense of $2.7 million annually in future periods. This increase has no effect on cash rent payments at the start of the lease term, and will only result in additional cash outlay as the 3 percent annual increases take effect each year. In addition, there was an increase in lease expense of $0.2 million resulting from rent increases for lessor funded property renovations. Offsetting these increases in rent were reduced rent following the purchase of a leased facility in 2005 and the extension of a lease at the beginning of 2006 covering four nursing centers that provided for the elimination of certain contingent rent expense.
Professional liability. Professional liability expense was a net benefit of $4.8 million in 2006, compared to a net benefit of $4.0 million in 2005, an increase in net benefit of $0.8 million, or 22.2%. Our cash expenditures for self-insured professional liability costs were $3.4 million and $4.1 million for the twelve month periods ended December 31, 2006 and 2005, respectively. During 2006, we reduced our total recorded liabilities for self-insured professional liability risks to $25.7 million, down from $34.5 million at December 31, 2005.
General and administrative expense. General and administrative expense increased to $16.0 million in 2006 from $13.3 million in 2005, an increase of $2.7 million or 20.0%. The increase is primarily attributable to increased compensation costs, and consulting costs related to compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002.
Compensation costs were approximately $1.2 million higher in 2006 than in 2005. Salary costs increased approximately $0.3 million, or 4%, due to normal merit and inflationary increases and approximately $0.4 million due to new positions added to improve operating and financial controls. In addition, incentive compensation costs were approximately $0.5 million higher in 2006 compared to 2005 as a result of improved operating performance.
We were required to comply with the internal control reporting requirements of the Sarbanes-Oxley Act of 2002 beginning with this annual report on Form 10-K, and compliance costs have resulted in an increase in general and administrative expense of approximately $0.7 million in 2006 compared to 2005.
As a percentage of total net revenues, general and administrative expense was approximately 7.4% in 2006 and 6.5% in 2005.
Stock-based compensation. During 2006, we recorded a charge of approximately $5.2 million related to stock option grants that were approved by shareholders at our annual meeting on June 1, 2006. Expense related to this grant is being recorded over the vesting period of the options. Most options vested during the second quarter of 2006 and the remaining options vest through December 2007.
Depreciation. Depreciation expense was approximately $3.7 million in 2006 compared to $3.5 million in 2005, an increase of $0.2 million or 4.5%. The increase was primarily due to the purchase of a leased facility in 2005.
Foreign currency transaction gain. A foreign currency transaction gain of approximately $21,000 was recorded in 2006, compared to $161,000 in 2005. Foreign currency transaction gains and losses result from foreign currency translation of a note receivable from the sale of our Canadian operations in 2004.
Interest expense. Interest expense increased to $3.7 million in 2006 from $3.4 million in 2005, an increase of $0.3 million or 9.6%. Interest expense increased as a result of new debt issued in connection with the acquisition of a facility as well as the interest rate increases on our variable rate debt. These increases were partially offset by a reduction in interest as a result of payments of debt from proceeds of the sale of discontinued operations, principal payments made in connection with a refinancing transaction in August 2006, and other principal payments.
Debt retirement costs. Debt retirement costs of $0.2 million are related to unamortized deferred finance costs of refinanced loans that were written off following the refinancing transaction we completed in August 2006.
Income from continuing operations before income taxes; income from continuing operations per common share. As a result of the above, continuing operations reported income before income taxes of $12.4 million in 2006 compared to income before income taxes of $16.8 million in 2005. The benefit for income taxes was $9.5 million in 2006, compared to $13.8 million in 2005. Our effective tax rate differs materially from the statutory rate mainly due to changes in our valuation allowance for net deferred tax assets. In 2006 and 2005, we recorded a deferred tax benefit of approximately $9.7 million and $13.9 million, respectively, to reduce deferred tax asset valuation allowances, based on improvements in our financial position and our updated forecast of income available to support the turnaround of existing net operating loss carryforward credits. In future periods, we will continue to assess the need for and adequacy of the remaining valuation allowance. The basic and diluted income per common share from continuing operations were $3.73 and $3.34, respectively, in 2006, as compared to a basic and diluted income per common share from continuing operations of $5.29 and $4.69, respectively, in 2005.
Income from discontinued operations. Operating income of discontinued operations, net of taxes, was approximately $0.1 million in 2006, compared to a loss from discontinued operations of $5.7 million in 2005. Losses from the disposition of discontinued operations of $0.1 million, net of related taxes, were recorded in 2006, compared to a gain of $0.4 million recorded in 2005.
Year Ended December 31, 2005 Compared With Year Ended December 31, 2004
In 2004 and 2005 we entered into several divestiture and lease termination transactions and our consolidated financial statements have been reclassified to present such transactions as discontinued operations. Accordingly, the related revenue, expenses, assets, liabilities and cash flows have been reported separately, and the discussion below addresses principally the results of our continuing operations.
Revenues. Net revenues increased to $203.7 million in 2005 from $191.2 million in 2004, an increase of $12.5 million, or 6.5%. The increase in revenues is due to Medicare rate increases, increased Medicare utilization and increased Medicaid rates in certain states. As a percentage of total census, Medicare days increased to 13.0% in 2005 from 12.7% in 2004. Medicare revenues were 30.0% of patient revenue in 2005 and 29.3% in 2004, while Medicaid and similar programs were 58.0% in 2005 compared to 59.4% in 2004.
Ancillary service revenues, prior to contractual allowances, increased to $42.2 million in 2005 from $36.7 million in 2004, an increase of $5.5 million, or 14.9%. The increase is primarily attributable to increased Medicare census and higher acuity patients.
Operating expense. Operating expense increased to $155.5 million in 2005 from $147.8 million in 2004, an increase of $7.7 million, or 5.2%. As a percentage of patient and resident revenues, operating expense decreased to 76.4% in 2005 from 77.3% in 2004. The increase in operating expense is primarily attributable to cost increases related to wages and benefits, partially offset by a decrease in employee health insurance costs. The decrease in operating costs as a percent of patient and resident revenues is primarily due to the effects of increases in Medicare and Medicaid rates and increased Medicare utilization, as discussed above.
The largest component of operating expenses is wages, which increased to $92.0 million in 2005 from $86.2 million in 2004, an increase of $5.8 million, or 6.7%. This increase is primarily attributable to an increase in wages as a result of competitive labor markets in most of the areas in which we operate and increased Medicare census. This increase was partially offset by a reduction in employee health insurance costs, which were $1.4 million lower in 2005 compared to 2004. Employee health insurance costs can vary significantly from year to year, and this large decrease is not expected to continue in 2006.
Lease expense. Lease expense increased to $15.8 million in 2005 from $15.3 million in 2004. The increase in rent expense is primarily due to contingent rent expense incurred in connection with certain leases, and to increased expense in connection with a lease for one facility that was renewed effective April 2005. These increases were partially offset by reduced rent following the purchase of a leased facility in 2005.
Professional liability. Professional liability expense in 2005 resulted in a net benefit of $4.0 million, compared to a benefit of $1.8 million in 2004, an increase in net benefit of $2.2 million. Our cash expenditures for self-insured professional liability costs were $4.1 million and $3.3 for the twelve month periods ended December 31, 2005 and 2004, respectively. During 2005, we reduced our total recorded liabilities for self-insured professional liability risks to $34.5 million, down from $42.9 million at December 31, 2004.
General and administrative expense. General and administrative expense increased to $13.3 million in 2005 from $11.7 million in 2004, an increase of $1.6 million or 13.8%. The increase is primarily attributable to increased compensation costs, compliance costs and travel expenses. As a percentage of total net revenues, general and administrative expense was approximately 6.5% in 2005 and 6.1% and 2004.
Asset impairment and other charges. During 2005 and 2004, we recorded impairment charges in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and certain other charges as follows:
During 2005, an impairment charge of $4.4 million was recorded for eleven assisted living facilities to reduce the net book value of these properties to their estimated net realizable value. These properties were sold in the second quarter of 2006. As a result of projected cash flows, impairment charges of $8.4 million were recorded in 2004 for five nursing centers, including three leased facilities and two owned facilities, and for six owned assisted living facilities.
During 2004, we terminated leases covering three nursing centers, and settled a dispute related to an assisted living facility lease termination from 2002. We incurred lease termination charges of approximately $341,000 in 2004, consisting of the remaining net book value of the related facilities, costs of completing the transactions and settlement charges. These lease termination charges are included in the results of discontinued operations.
Depreciation. Depreciation expense increased to $3.5 million in 2005 from $3.2 million in 2004, an increase of $0.3 million or 8.2%. The increase was primarily due to capital expenditures made during the periods.
Foreign currency transaction gain. A foreign currency transaction gain of $161,000 was recorded in 2005, compared to a gain of $784,000 in 2004. These gains result from foreign currency translation of a note receivable from the sale of our Canadian operations.
Interest income. Interest income increased to $534,000 in 2005 from $286,000 in 2004, an increase of $248,000. The majority of this interest income is non-cash interest income related to amortization of discount on a note receivable recorded in connection with the May 2004 sale of our Canadian subsidiary.
Interest expense. Interest expense increased to $3.4 million in 2005 from $3.1 million in 2004, an increase of $0.3 million or 10.2%. Interest expense increased as a result of new notes issued in connection with the acquisition of a facility and the settlement of certain professional liability claims and other disputes, and interest rate increases on our variable rate debt. These increases were offset by reduction in interest as a result of the payment of debt.
Income from continuing operations before income taxes; income from continuing operations per common share. As a result of the above, continuing operations reported income before income taxes of $16.8 million in 2005 compared to income before income taxes of $12.8 million in 2004. The benefit for income taxes was $13.8 million in 2005, compared to a provision for income taxes of $0.3 million in 2004. Our effective tax rate differs materially from the statutory rate mainly due to changes in our valuation allowance for net deferred tax assets. During 2005, we reduced the valuation allowance and recorded a deferred tax benefit of $13.9 million based on the Company’s achieved earnings trend and outlook. The basic and diluted income per share from continuing operations were $5.29 and $4.69, respectively, in 2005, as compared to a basic and diluted income per share from continuing operations of $2.16 and $1.93, respectively, in 2004.
Income from discontinued operations. Loss from discontinued operations, net of taxes, was approximately $5.7 million in 2005 compared to a loss of $10.0 million in 2004. The reduction in the loss is due primarily to a reduction in the amount of impairment charges recorded related to our assisted living
operations and the sale of nursing centers in Texas in 2004 and 2005. In addition, gains from the disposition of discontinued operations of $0.4 million and $0.3 million, net of related taxes, were recorded in 2005 and 2004, respectively.
Liquidity and Capital Resources
On October 20, 2006 we entered into a Restructuring Stock Issuance and Subscription Agreement (“Restructuring Agreement”) to restructure our Series B Redeemable Convertible Preferred Stock held by Omega Healthcare Investors (together with its subsidiaries, “Omega”), a publicly owned REIT, eliminating the option of Omega to convert the Preferred Stock into shares of Advocat common stock. Advocat and Omega also entered into a Third Amendment to Consolidated Amended and Restated Master Lease (“Lease Amendment”) to extend the term of our lease covering 29 nursing centers we currently lease from Sterling Acquisition Corp., a wholly-owned subsidiary of Omega. In addition, Omega agreed to provide up to $5 million to fund capital improvements made to certain nursing centers by June 30, 2008. Details of these transactions are described below.
Under the terms of the Restructuring Agreement, the Series B Redeemable Convertible Preferred Stock (“Series B Preferred Stock”) held by Omega was exchanged for a new Series C Preferred Stock that is not convertible. At the time of the Restructuring Agreement, the Series B Preferred Stock had a recorded value of approximately $4.9 million, including accrued dividends, at an annual rate of 7% of the stated value, compounded quarterly, and was convertible into approximately 792,000 shares of common stock.
The Restructuring Agreement required us to issue to Omega 5,000 shares of Series C Preferred Stock in exchange for the 393,658 shares of Series B Preferred Stock held by Omega. The new Series C Preferred Stock has a stated value of approximately $4.9 million and carries an annual dividend rate of 7% of its stated value. The Series C Preferred Stock will accrue dividends quarterly. The Series C Preferred Stock is not convertible, but is redeemable at its stated value at Omega’s option after September 30, 2010, and is redeemable at its stated value at our option after September 30, 2007, subject to certain limitations. In connection with the termination of the conversion feature, we agreed to pay Omega an additional $687,000 annually under the Lease Amendment.
In connection with the Restructuring Agreement, we also replaced a Subordinated Promissory Note which was convertible at our option with a new Subordinated Note, which is not convertible. The new Subordinated Note is in the principal amount of approximately $2.5 million, bears interest at 7% and matures on September 30, 2007. Except for eliminating the conversion feature, the terms of the new Subordinated Note are the same as the original Subordinated Promissory Note.
Under the terms of the Lease Amendment, Advocat and Omega also agreed to amend and renew the master lease covering 29 nursing centers. The initial term of the lease was set to expire in September 2010, with a ten year renewal option. The amended master lease commenced on October 1, 2006, and extends to September 30, 2018. The Lease Amendment also provides for a renewal option of an additional twelve years. Other than the change in rent associated with the restructuring of the preferred stock described above, there was no change in the base rental amounts as a result of the Lease Amendment. Consistent with prior terms, the lease provides for annual increases in lease payments equal to the lesser of two times the increase in the consumer price index or 3 percent. Under generally accepted accounting principles, we are required to report these scheduled rent increases on a straight line basis over the 12 year term of the renewal period. As a result of accruing the scheduled rent increases, our annual rent expense increased by approximately $2.7 million effective October 1, 2006. This increase has no effect on cash rent payments at the start of the lease term, and will only result in additional cash outlay as the 3 percent annual increases take effect each year.
This lease amendment, together with an earlier amendment in 2005, provides financing of up to $10 million to fund capital improvements made to certain nursing centers leased from Omega. The annual base rent related to these nursing centers will be increased to reflect the amount of capital improvements made to the facilities. As of December 31, 2006, we had incurred expenditures of $5.0 million for these improvements.
On August 7, 2006, we entered into an agreement with our commercial mortgage lender, Capmark Finance Inc. (“Capmark”), for a comprehensive refinancing of our long term debt. Under the terms of the new agreement, Capmark provided mortgage debt of approximately $22.5 million with a five year maturity and a term note of approximately $8.1 million with a four year maturity to refinance our remaining mortgage and bank term debt. The proceeds of these new loans were used to retire the existing debt and to fund a $1.1 million renovation of a nursing center that is part of the collateral for the mortgage loans. In connection with this loan, we made a payment of approximately $2.6 million to reduce outstanding debt. The new loans include various financial covenants, the most restrictive of which relate to cash flow, debt service coverage ratios, and liquidity. We are in compliance with these new covenants. We expensed existing deferred financing costs of $0.2 million related to the debt that was retired and recorded new deferred loan costs of $0.8 million as part of the refinancing transaction.
On March 17, 2006, we entered into a two year renewal of our term notes and working capital line of credit agreements with our primary bank lender. In addition, the lender agreed to amend certain covenants of the notes to bring us into compliance with such covenants. These term notes were repaid with proceeds from the refinance transaction on August 7, 2006, as described above. The working capital line of credit remains in place with the bank lender.
As of December 31, 2006, we had no borrowings under our working capital line of credit. The maximum outstanding balance of the working capital line of credit is $2.3 million. There are certain limitations based on borrowing base restrictions. The working capital line of credit matures in January 2008 with interest at either LIBOR plus 2.5% or the bank’s prime rate plus 0.50% (up to a maximum of 9.5%).
We have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. Due to our past claim experience and increasing cost of claims throughout the long-term care industry, the premiums paid by us for professional liability and other liability insurance to cover future periods exceeds the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, we have purchased professional liability insurance coverage for our facilities that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. As a result, we are effectively self-insured and expect to remain so for the foreseeable future.
We have essentially exhausted all general and professional liability insurance available for claims first made during the period from March 9, 2001 through March 9, 2007. For claims made during the period from March 10, 2007 through March 9, 2008, we maintain insurance coverage limits of $100,000 per medical incident and total aggregate policy coverage limits of $500,000.
As of December 31, 2006, we have recorded total liabilities for reported and settled professional liability claims and estimates for incurred but unreported claims of $25.7 million. A significant judgment entered against us in one or more of these legal actions could have a material adverse impact on our financial position and cash flows. Future committed settlements total $0.7 million, and are payable over the next three months. Included in that future commitment is approximately $0.6 million that was settled after December 31, 2006 and is fully reserved in our professional liability claims accrual. Certain of these commitments have been evidenced by promissory notes which have been included with debt in the accompanying balance sheet. Settlements of currently pending claims will require additional cash expenditures.
Net cash provided by operating activities of continuing operations before changes in other assets and liabilities totaled $14.5 million, $13.2 million and $11.5 million in 2006, 2005 and 2004, respectively. These amounts primarily represent the cash flows from net operations. The effects of working capital changes were to provide $0.6 million of cash in 2006 and to use cash of $3.6 million and $5.9 million, respectively, in 2005 and 2004, resulting in net cash provided by continuing operations of $15.1 million, $9.6 million and $5.6 million in 2006, 2005 and 2004, respectively. Discontinued operations provided cash of $0.2 million and $2.0 million in 2006 and 2004, respectively, and used $0.6 million of cash in 2005.
Investing activities of continuing operations provided cash of $6.3 million and $2.8 million in 2006 and 2004, respectively, and used $8.3 million of cash in 2005. These amounts primarily represent proceeds from the sale of discontinued operations, cash used for the purchase of a nursing center in 2005, and cash used for purchases of property, plant and equipment. We have used between $3.0 million and $4.1 million for capital expenditures of continuing operations in each of the three calendar years ending December 31, 2006. Such expenditures were primarily for facility improvements and equipment, which were financed principally through working capital. For the year ending December 31, 2007, we anticipate that capital expenditures for improvements and equipment for our existing facility operations will be higher as we complete facility renovations at certain owned facilities. Investing activities of discontinued operations used no cash in 2006 and used $0.8 million and $1.3 million in 2005 and 2004, respectively.
Financing activities of continuing operations used cash of $16.4 million and $8.0 million in 2006 and 2004, respectively, and provided $1.4 million of cash of cash in 2005. In 2006 and 2004, proceeds from the sale of discontinued operations were used to repay debt. The cash provided in 2005 primarily represents funds from loan proceeds used to acquire a nursing center. There were no cash flows from financing activities of discontinued operations in 2006 or 2005, and discontinued operations used cash of $44,000 in 2004. No interest costs or debt were allocated to discontinued operations.
Facility Renovations
After a strategic review, we determined that renovating certain facilities offered the opportunity to improve occupancy, quality of care and profitability. We developed a plan to identify those facilities with the greatest potential for benefit, and began the renovation program during 2005. Renovation projects on four facilities were completed during 2006. We expect to complete two additional projects in the first quarter of 2007, and management is currently developing plans to begin additional facility renovations.
A total of $5.7 million has been spent on these renovation programs to date, with $5.0 million spent on facilities leased from Omega and $0.7 million spent on owned facilities. The amounts spent on the facilities leased from Omega are financed through increased rent, and are not reflected as capital expenditures.
For the three facilities with renovations completed before the beginning of the fourth quarter, fourth quarter occupancy improved from 60.9% in 2005 to 70.6% in 2006, and Medicare census as a percent of total increased from 14.4% in 2005 to 17.9% in 2006. No assurance can be given that these facilities will continue to show such occupancy or revenue mix improvement or that the other renovated facilities will experience similar improvements.
West Virginia Facility Option Agreement
We have entered into an option agreement to purchase certain assets of a skilled nursing facility in West Virginia. We recently made an application to state regulatory authorities to allow us to operate the facility, and construct a new 90 bed replacement facility. In the event our application is approved, we will seek to arrange financing and begin construction of the replacement facility.
Receivables
Our operations could be adversely affected if we experience significant delays in reimbursement from Medicare, Medicaid and other third-party revenue sources. Our future liquidity will continue to be dependent upon the relative amounts of current assets (principally cash, accounts receivable and inventories) and current liabilities (principally accounts payable and accrued expenses). In that regard, accounts receivable can have a significant impact on our liquidity. Continued efforts by governmental and third-party payors to contain or reduce the acceleration of costs by monitoring reimbursement rates, by increasing medical review of bills for services, or by negotiating reduced contract rates, as well as any delay by us in the processing of our invoices, could adversely affect our liquidity and results of operations.
Accounts receivable attributable to patient services of continuing operations totaled $18.7 million at December 31, 2006, compared to $18.6 million at December 31, 2005, representing approximately 31 and 33 days in accounts receivable at each period end, respectively.
The allowance for bad debt was $2.1 million at December 31, 2006, compared to $1.7 million at December 31, 2005. We continually evaluate the adequacy of our bad debt reserves based on patient mix trends, aging of older balances, payment terms and delays with regard to third-party payors, collateral and deposit resources, as well as other factors. We continue to evaluate and implement additional procedures to strengthen our collection efforts and reduce the incidence of uncollectible accounts.
Stock Exchange
During 2006, our common stock shares were approved for listing on the NASDAQ Capital Market and began trading there on September 12, 2006 under the symbol AVCA. Prior to our listing on the NASDAQ Capital Market our stock was quoted on the NASD’s OTC Bulletin Board under the symbol AVCA.
Inflation
We do not believe that our operations have been materially affected by inflation. We expect salary and wage increases for our skilled staff to continue to be higher than average salary and wage increases, as is common in the health care industry.
Recent Accounting Pronouncements
On July 13, 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In addition, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. Earlier application is permitted as long as the enterprise has not yet issued financial statements, including interim financial statements, in the period of adoption. The provisions of FIN 48 are to be applied to all tax positions upon initial adoption of this standard. Only tax positions that meet the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption of FIN 48. The cumulative effect of applying the provisions of FIN 48 should be reported as an adjustment to the opening balance of retained earnings for that fiscal year. We do not expect the adoption of FIN48 to have a material impact on our financial position, results of operations or cash flows.
In September 2006, the FASB issued SFAS No. 157; “Fair Value Measurements” (“SFAS No. 157”). This new standard provides guidance for using fair value to measure assets and liabilities and establishes a fair value hierarchy that prioritizes the information used to develop the measurements. Statement 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. The provisions of Statement 157 are effective for us beginning January 1, 2007. Earlier application is permitted, provided that the reporting entity has not yet issued financial statements for that fiscal year, including any financial statements for an interim period within that fiscal year. We do not expect the adoption of this new standard to have a material impact on our financial position.
Forward-Looking Statements
The foregoing discussion and analysis provides information deemed by Management to be relevant to an assessment and understanding of our consolidated results of operations and financial condition. This discussion and analysis should be read in conjunction with our consolidated financial statements included herein. Certain statements made by or on behalf of us, including those contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere, are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those contemplated by the forward-looking statements made herein. In addition to any assumptions and other factors referred to specifically in connection with such statements, other factors could cause our actual results to differ materially from the results expressed or implied in any forward-looking statements including, but not limited to, changes in governmental reimbursement, government regulation and health care reforms, the increased cost of borrowing under our credit agreements, ability to control ultimate professional liability costs, the accuracy of our estimate of our anticipated professional liability expense, the impact of future licensing surveys, the outcome of regulatory proceedings alleging violations of laws and regulations governing quality of care or violations of other laws and regulations applicable to our business, our ability to control costs, changes to our valuation of deferred tax assets, changes in occupancy rates in our facilities, changing economic conditions as well as others. Investors also should refer to the risks identified in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as risks identified in “Part 1. Item 1A. Risk Factors” for a discussion of various risk factors of the Company and that are inherent in the health care industry. Given these risks and uncertainties, we can give no assurances that these forward-looking statements will, in fact, transpire and, therefore, caution investors not to place undue reliance on them. These assumptions may not materialize to the extent assumed, and risks and uncertainties may cause actual results to be different from anticipated results. These risks and uncertainties also may result in changes to the Company’s business plans and prospects. Such cautionary statements identify important factors that could cause our actual results to materially differ from those projected in forward-looking statements. In addition, we disclaim any intent or obligation to update these forward-looking statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The chief market risk factor affecting our financial condition and operating results is interest rate risk. As of December 31, 2006, we had outstanding borrowings of approximately $31.5 million, including $2.7 million in fixed-rate borrowings and $28.8 million in variable-rate borrowings. In the event that interest rates were to change 1%, the impact on future cash flows would be approximately $288,000 annually, representing the impact of changed interest expense on variable rate debt.
We have a note receivable denominated in Canadian dollars related to the sale of our Canadian operations. This note is currently recorded on our balance sheet at $5.3 million US based on the outstanding balance of the note and the exchange rate as of December 31, 2006. The carrying value of the note in our financial statements will be increased or decreased each period based on fluctuations in the exchange rate between US and Canadian currencies, and the effect of such changes will be included as income or loss in our statement of operations in the period of change. In 2006 and 2005, we reported transaction gains of $21,000 and $161,000, respectively, as a result of the effect of changes in the currency exchange rates on this note. A further change of 1% in the exchange rate between US and Canadian currencies would result in a corresponding increase or decrease to earnings of approximately $53,000.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Audited financial statements are contained on pages through of this Annual Report on Form 10-K and are incorporated herein by reference. Audited supplemental schedule data is contained on pages S-1 and S-2 of this Annual Report on Form 10-K and is incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures
Advocat, with the participation of our principal executive and financial officers, has evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of December 31, 2006. Based on this evaluation, the principal executive and financial officers have determined that such disclosure controls and procedures are effective to ensure that information required to be disclosed in our filings under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.
Management’s Report on Internal Control over Financial Reporting
We are responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). We assessed the effectiveness of our internal control over financial reporting as of December 31, 2006. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. We have concluded that, as of December 31, 2006, our internal control over financial reporting is effective based on these criteria. Our independent registered public accounting firm, BDO Seidman, LLP, has issued an audit report on our assessment of our internal control over financial reporting, which is included herein.
Changes in Internal Control over Financial Reporting
There has been no change (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal control over financial reporting that has occurred during our fiscal quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect our internal control over financial reporting.
Our management does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefit of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
Advocat Inc
Brentwood, Tennessee
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting, that Advocat Inc. (the “Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles,
and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006 based on the COSO criteria.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2006 and 2005 and the related consolidated statements of income, net comprehensive income, shareholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2006 and our report dated March 13, 2007 expressed an unqualified opinion thereon.
/s/ BDO Seidman, LLP
Memphis, Tennessee
March 13, 2007
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information concerning our Directors and Executive Officers is incorporated herein by reference to our definitive proxy materials for our 2007 Annual Meeting of Shareholders.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information concerning Executive Compensation is incorporated herein by reference to our definitive proxy materials for our 2007 Annual Meeting of Shareholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS
Information concerning Security Ownership of Certain Beneficial Owners and Management is incorporated herein by reference to our definitive proxy materials for our 2007 Annual Meeting of Shareholders.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information concerning Certain Relationships and Related Transactions is incorporated herein by reference to our definitive proxy materials for our 2007 Annual Meeting of Shareholders.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information concerning the fees and services provided by our principal accountant is incorporated herein by reference to our definitive proxy materials for our 2007 Annual Meeting of Shareholders.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
The Financial statements and schedules for us and our subsidiaries required to be included in Part II, Item 8 are listed below.
Exhibits
The exhibits filed as part of this Report on Form 10-K are listed in the Exhibit Index immediately following the financial statement pages.
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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ Wallace E. Olson
/s/ William C. O’Neil. Jr.
Wallace E. Olson
William C. O’Neil, Jr.
Chairman of the Board
Director
March 13, 2007
March 13, 2007
/s/ William R. Council, III
/s/ Richard M. Brame
William R. Council, III
Richard M. Brame
President and Chief Executive Officer
Director
Director
March 13, 2007
March 13, 2007
/s/ Robert Z. Hensley
Robert Z. Hensley
Director
March 13, 2007
*
Indicates management contract or compensatory plan or arrangement.
ADVOCAT INC. AND SUBSIDIARIES
Consolidated Financial Statements
For the Years Ended December 31, 2006, 2005 and 2004
Together with Report of Independent Registered Public Accounting Firm
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Advocat Inc.
Brentwood, Tennessee
We have audited the accompanying consolidated balance sheets of Advocat Inc. as of December 31, 2006 and 2005 and the related consolidated statements of income, net comprehensive income, shareholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2006. We have also audited the schedule listed in the accompanying index. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedule are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedule, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedule. 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 Advocat Inc. at December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
Also, in our opinion, the schedule presents fairly, in all material aspects, the information set forth therein.
As discussed in Note 2 to the consolidated financial statements, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payment.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Advocat Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 13, 2007 expressed an unqualified opinion thereon.
/s/ BDO Seidman, LLP
Memphis, Tennessee
March 13, 2007
ADVOCAT INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2006 AND 2005
The accompanying notes are an integral part of these consolidated financial statements.
ADVOCAT INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes are an integral part of these consolidated financial statements.
ADVOCAT INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (DEFICIT)
The accompanying notes are an integral part of these consolidated financial statements.
ADVOCAT INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF NET COMPREHENSIVE INCOME
The accompanying notes are an integral part of these consolidated financial statements.
ADVOCAT INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Continued)
ADVOCAT INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Continued)
NON-CASH TRANSACTIONS:
During 2006, the Company accrued, but did not pay, preferred stock dividends of $168,000. In 2005 and 2004, the Company accrued, but did not pay, preferred stock dividends of $318,000 and $297,000, respectively. Following the preferred stock restructuring described in Note 3, the Company began paying preferred stock dividends, and paid dividends of $172,000 as shown above.
During 2005 and 2004, promissory notes totaling $481,000 and $3,331,000, respectively, were issued in connection with the settlement of certain professional liability claims and other disputes.
The accompanying notes are an integral part of these consolidated financial statements.
ADVOCAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004
1.
COMPANY AND ORGANIZATION
Advocat Inc. (together with its subsidiaries, “Advocat” or the “Company”) provides long-term care services to nursing center patients in eight states, primarily in the Southeast. The Company’s centers provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care centers, the Company offers a variety of comprehensive rehabilitation services as well as nutritional support services.
As of December 31, 2006, the Company’s continuing operations consist of 43 nursing centers with 4,505 licensed nursing beds and 66 assisted living units. The Company’s continuing operations include nine owned nursing centers and 34 leased nursing centers. The Company’s continuing operations include centers in Alabama, Arkansas, Florida, Kentucky, Ohio, Tennessee, Texas and West Virginia.
2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Consolidation
The consolidated financial statements include the operations and accounts of Advocat and its subsidiaries, all wholly-owned. All significant intercompany accounts and transactions have been eliminated in consolidation. As discussed in Note 10, the consolidated financial statements of the Company have been reclassified to present the results of certain operations as discontinued operations.
The Company is managed as one reporting unit for internal purposes and for decision making. Therefore, management has concluded that the Company is operated as a single segment, as defined in Statement of Financial Accounting Standards (“SFAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information.”
Revenues
Patient Revenues
The fees charge by the Company to patients in its nursing centers are recorded on an accrual basis. These rates are contractually adjusted with respect to individuals receiving benefits under federal and state-funded programs and other third-party payors. Rates under federal and state-funded programs are determined prospectively for each facility and may be based on the acuity of the care and services provided. These rates may be based on facility’s actual costs subject to program ceilings and other limitations or on established rates based on acuity and services provided as determined by the federal and state-funded programs. Amounts earned under federal and state programs with respect to nursing home patients are subject to review by the third-party payors which may result in retroactive adjustments. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. Retroactive adjustments, if any, are recorded when objectively determinable, generally within three years of the close of a reimbursement year depending upon the timing of appeals and third-party settlement reviews or audits. During the years ended December 31, 2006, 2005 and 2004, the Company recorded $(40,000), $315,000 and $146,000 of net favorable (unfavorable) estimated settlements from federal and state programs for periods prior to the beginning of fiscal 2005, 2004 and 2003, respectively.
Allowance for Doubtful Accounts
The Company’s allowance for doubtful accounts is estimated utilizing current agings of accounts receivable, historical collections data and other factors. Management monitors these factors and determines the estimated provision for doubtful accounts. Historical bad debts have generally resulted from uncollectible private balances, some uncollectible coinsurance and deductibles and other factors. Receivables that are deemed to be uncollectible are written off. The allowance for doubtful accounts balance is assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified.
The Company includes provisions for doubtful accounts in operating expenses in its consolidated statements of operations. The provisions for doubtful accounts of continuing operations were $1,631,000, $1,560,000 and $1,359,000 for 2006, 2005 and 2004, respectively.
Lease Expense
As of December 31, 2006, the Company operates 34 nursing centers under operating leases, including 33 owned or financed by Omega Healthcare Investors, Inc. (together with its subsidiaries, “Omega”) and one owned by another party. The Company’s operating leases generally require the Company to pay stated rent, subject to increases based on changes in the Consumer Price Index, a minimum percentage increase, or increases in the net revenues of the leased properties. The Company’s Omega leases required the Company to pay certain scheduled rent increases. Such scheduled rent increases are recorded as additional lease expense on a straight-line basis recognized over the term of the related leases.
See Notes 3 and 14 for a discussion regarding the amendment of the Company’s master lease with Omega in 2006 and the termination of leases for certain facilities.
Classification of Expenses
The Company classifies all expenses (except stock based compensation, interest, depreciation and lease expenses) that are associated with its corporate and regional management support functions as general and administrative expenses. All other expenses (except professional liability, interest, depreciation and lease expenses) incurred by the Company at the facility level are classified as operating expenses.
Property and Equipment
Property and equipment are recorded at cost with depreciation being provided over the shorter of the remaining lease term (where applicable) or the assets’ estimated useful lives on the straight-line basis as follows:
Interest incurred during construction periods is capitalized as part of the building cost. Maintenance and repairs are expensed as incurred, and major betterments and improvements are capitalized. Property and equipment obtained through purchase acquisitions are stated at their estimated fair value determined on the respective dates of acquisition.
In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company evaluates the recoverability of the carrying values of its properties on a property by property basis. On a quarterly basis, the Company reviews its properties for recoverability when events or circumstances, including significant physical changes in the property, significant adverse changes in general economic conditions, and significant deteriorations of the underlying cash flows of the property, indicate that the carrying amount of the property may not be recoverable. The need to recognize an impairment is based on estimated future cash flows from a property compared to the carrying value of that property. If recognition of an impairment is necessary, it is measured as the amount by which the carrying amount of the property exceeds the fair value of the property. See Note 5 for discussion of impairment provisions recorded in 2005 and 2004.
Cash and Cash Equivalents
Cash and cash equivalents include cash on deposit with banks and all highly liquid investments with original maturities of three months or less.
Restricted Cash
Restricted cash consists of funds on deposit with a bank securing certain obligations.
Deferred Financing and Other Costs
The Company records deferred financing costs for expenditures related to borrowing or amending debt and leases. These expenditures include bank and attorneys fees. Financing costs are amortized using the effective interest method over the term of the related debt. The amortization is reflected as interest expense in the accompanying consolidated statements of operations. Deferred lease costs are amortized on a straight-line basis over the term of the related leases. See Note 9.
Cash Restricted for Capital Expenditures
Cash Restricted for Capital Expenditures represent amounts held in a construction escrow account controlled by Capmark Finance Inc. (“Capmark”) from which the Company draws proceeds from as it completes a $1.1 million renovation of a nursing center that is part of the collateral for a mortgage loan. This renovation is expected to be completed near the end of the first quarter in 2007. See Note 9 for further discussion.
Self Insurance
Self insurance reserves primarily represent the accrual for self insured risks associated with general and professional liability claims, employee health insurance and workers compensation. The Company’s health insurance reserve is based on known claims incurred and an estimate of incurred but unreported claims determined by an analysis of historical claims paid. The Company’s workers compensation reserve relates primarily to periods of self insurance prior to May 1997 and consists of an estimate of the future costs to be incurred for the known claims.
The Company retains a third-party actuarial firm to estimate the appropriate accrual for incurred general and professional liability claims. The actuary primarily uses historical data regarding the frequency and cost of the Company’s claims over a multi-year period and information regarding the Company’s number of occupied beds to develop estimates of the Company’s ultimate professional liability cost for current periods. The actuary estimates the Company’s professional liability accrual for past periods by using currently-known information to adjust the initial reserve that was created for that period. All losses are projected on an undiscounted basis. The self insurance reserves include estimates of liability for incurred but not reported claims, estimates of liability for reported but unresolved claims, actual liabilities related to settlements, including settlements to be paid over time, and estimates of related legal costs incurred and expected to be incurred.
One of the key assumptions in the actuarial analysis is that historical losses provide an accurate forecast of future losses. Changes in legislation such as tort reform, changes in our financial condition, changes in our risk management practices and other factors may affect the severity and frequency of claims incurred in future periods as compared to historical claims.
Another key assumption is the limit of claims to a maximum of $4.5 million. The actuary has selected this limit based on the Company’s historical data. While most of the Company’s claims have been for amounts less than the $4.5 million, there have been claims at higher amounts, and there may be claims above this level in the future. The facts and circumstances of each claim vary significantly, and the amount of ultimate liability for an individual claim may vary due to many factors, including whether the case can be settled by agreement, the quality of legal representation, the individual jurisdiction in which the claim is pending, and the views of the particular judge or jury deciding the case. To date, the
Company has not experienced an uninsured loss in excess of this limit. In the event that the Company believes it has incurred a loss in excess of this limit, an adjustment to the reserves determined by the actuary would be necessary.
General and professional liability claims are inherently uncertain and actual results could differ from estimates and cause the Company’s reported net income to vary significantly from period to period. The self-insurance reserves are assessed on a quarterly basis based on currently available information. The amounts recorded for professional and general liability claims are adjusted for revisions in estimates and differences between actual settlements and reserves as determined each period with changes in estimated losses being recorded in the consolidated statements of operations in the period identified.
Income Taxes
The Company utilizes SFAS No. 109, “Accounting for Income Taxes,” which requires an asset and liability approach for financial accounting and reporting of income taxes. Under this method, deferred tax assets and liabilities are determined based upon differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax laws that will be in effect when the differences are expected to reverse. The Company assesses the need for a valuation allowance to reduce the deferred tax assets by the amount that is believed is more likely not to be utilized through the turnaround of existing temporary differences, future earnings, or a combination thereof, including certain net operating loss carryforwards we do not expect to realize due to change in ownership limitations. See Note 13 for additional information related to the provision for income taxes.
Disclosure of Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, receivables, trade accounts payable and accrued expenses approximate fair value because of the short-term nature of these accounts. The carrying amount of the Company’s debt approximates fair value because the interest rates approximate the current rates available to the Company and its individual facilities. The Company’s self-insurance reserves are reported on an undiscounted basis as the timing of estimated settlements cannot be determined.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Foreign Operations and Currency Translation Policies
The results of operations and the financial position of the Canadian operations have been prepared from records maintained in Canada and translated at the respective average rates (for purposes of the consolidated statements of operations) and respective year-end rates (for purposes of the consolidated balance sheets). Translation gains and losses are reported as a component of accumulated other comprehensive income in shareholders’ equity. As discussed in Note 10, these Canadian operations were sold in 2004 and as a result the accumulated foreign currency translation gains and losses were realized and recognized in income from discontinued operations as part of the gain on sale.
Net Income per Common Share
The Company utilizes SFAS No. 128, “Earnings Per Share,” for the financial reporting of net income per common share. Basic earnings per common share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per common share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or otherwise resulted in the issuance of common stock that then shared in the earnings of the Company.
Stock-Based Compensation
Beginning January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based Payment,” using the modified prospective method, in which compensation cost is recognized (a) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date. The Company had no unvested awards granted to employees on the effective date. In March 2005, the United States Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 107 (“SAB 107”), which provides supplemental implementation guidance for SFAS No. 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).
Prior to January 1, 2006, the Company accounted for stock-based compensation using the intrinsic value method as prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, and the related Interpretations (“APB No. 25”). Under APB No. 25, no compensation cost related to stock options was recognized because all options were issued with exercise prices equal to the fair market value at the date of grant. Because the Company elected to use the modified prospective method in adopting the provisions of SFAS No. 123R, results for prior periods have not been restated. Had compensation cost for the Company’s stock-based compensation plans in prior periods been determined consistent with SFAS No. 123R, the Company’s net income for common stock and net income per common share would not have differed from the amounts reported for 2005 and 2004.
See Note 11 for additional disclosures about the Company’s stock-based compensation plans.
Recent Accounting Pronouncements
On July 13, 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In addition, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. Earlier application is permitted as long as the enterprise has not yet issued financial statements, including interim financial statements, in the period of adoption. The provisions of FIN 48 are to be applied to all tax positions upon initial adoption of this standard. Only tax positions that meet the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption of FIN 48. The cumulative effect of applying the provisions of FIN 48 should be reported as an adjustment to the opening balance of retained earnings for that fiscal year. The Company does not expect the adoption of FIN 48 to have a material impact on its financial position, results of operations or cash flows.
In September 2006, the FASB issued SFAS No. 157; “Fair Value Measurements” (“SFAS No. 157”). This new standard provides guidance for using fair value to measure assets and liabilities and establishes a fair value hierarchy that prioritizes the information used to develop the measurements. Statement 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. The provisions of Statement 157 are effective for the Company beginning January 1, 2007. Earlier application is permitted, provided that the reporting entity has not yet issued financial statements for that fiscal year, including any financial statements for an interim period within that fiscal year. The Company does not expect the adoption of this new standard to have a material impact on its financial position.
Reclassifications
As discussed in Note 10, the consolidated financial statements of the Company have been reclassified to reflect as discontinued operations certain divestitures and lease terminations. Certain amounts in the 2005 and 2004 financial statements related to continuing operations have also been reclassified to conform to the 2006 presentation.
3.
TRANSACTION WITH OMEGA
On October 20, 2006 the Company and Omega entered into a Restructuring Stock Issuance and Subscription Agreement (“Restructuring Agreement”) to restructure its Series B Redeemable Convertible Preferred Stock held by Omega, eliminating the option of Omega to convert the Preferred Stock into shares of Advocat common stock. Advocat and Omega also entered into a Third Amendment to Consolidated Amended and Restated Master Lease (“Lease Amendment”) to extend the term of its lease covering 29 nursing centers it currently leases from Sterling Acquisition Corp., a wholly-owned subsidiary of Omega. In addition, Omega agreed to provide up to $5 million to fund capital improvements made to certain nursing centers by June 30, 2008.
Preferred Stock Restructuring-
Under the terms of the Restructuring Agreement, the Series B Redeemable Convertible Preferred Stock (“Series B Preferred Stock”) held by Omega was exchanged for a new Series C Preferred Stock that is not convertible.
At the time of the Restructuring Agreement, the Series B Preferred Stock had a recorded value (including accrued dividends) of approximately $4.9 million. The Series B Preferred Stock accrued dividends at an annual rate of 7% of the stated value, compounded quarterly, and was convertible into approximately 792,000 shares of common stock.
The Restructuring Agreement required the Company to issue to Omega 5,000 shares of Series C Preferred Stock in exchange for the 393,658 shares of Series B Preferred Stock held by Omega. The new Series C Preferred Stock has a stated value of approximately $4.9 million and carries an annual dividend rate of 7% of its stated value. The Series C Preferred Stock pays quarterly cash dividends. The Series C Preferred Stock is not convertible, but is redeemable at its stated value at Omega’s option after September 30, 2010, and is redeemable at its stated value at the Company’s option after September 30, 2007, subject to certain limitations. In connection with the termination of the conversion feature, the Company agreed to pay Omega an additional $687,000 annually under the Lease Amendment.
The Company recorded the fair value of the elimination of the conversion feature as a reduction in Paid In Capital with an offsetting increase to record a premium on the Series C Preferred Stock. As a result, the Series C Preferred Stock was initially recorded at a total value of $11.6 million, equal to the stated value of the Series B Preferred Stock ($4.9 million) plus the negotiated value of the conversion feature, $6.7 million. The agreed upon additional rental payments of $687,000 annually were discounted over the twelve year term of the renewal so that the net present value of the payments equals the $6.7 million preferred stock premium. As payments are made, the preferred stock premium is reduced, interest expense is recorded and cash is reduced.
Subordinated Promissory Note-
In connection with the Restructuring Agreement, the Company also replaced a Subordinated Promissory Note which was convertible at the Company’s option with a new Subordinated Note, which is not convertible. The new Subordinated Note is in the principal amount of approximately $2.5 million, bears interest at 7% and matures on September 30, 2007. Except for eliminating the conversion feature, the terms of the new Subordinated Note are the same as the original Subordinated Promissory Note.
Master Lease Amendment-
Under the terms of the Lease Amendment, Advocat and Omega also agreed to amend and renew the master lease covering 29 nursing centers. The initial term of the lease was set to expire in September 2010, with a ten year renewal option. The amended master lease commenced on October 1, 2006, and extends to September 30, 2018. The Lease Amendment also provides for a renewal option of an additional twelve years. Other than the change in rent associated with the restructuring of the preferred stock described above, there was no change in the base rental amounts as a result of the Lease Amendment. Consistent with prior terms, the lease provides for annual increases in lease payments equal to the lesser of two times the increase in the consumer price index or 3 percent. Under generally accepted accounting principles, the Company reports these scheduled rent increases on a straight line basis over the 12 year term of the renewal period. As a result of accruing the scheduled rent increases, the Company’s annual rent expense increased by approximately $2.7 million effective October 1, 2006.
This increase has no effect on cash rent payments at the start of the lease term, and will only result in additional cash outlay as the 3 percent annual increases take effect each year.
The following table summarizes the Company’s annual cash rent payments under the lease renewal, including the 3% rent escalations but excluding the $687,000 annual payments related to the preferred stock restructuring:
The Company’s rent expense, recorded on a straight line basis, will be $15.5 million annually as of October 1, 2006.
In addition, Omega agreed to provide up to $5 million to fund capital improvements made to certain nursing centers by June 30, 2008. This funding is an addition to $5 million provided in 2005. The annual base rent related to these nursing centers will be increased to reflect the amount of capital improvements made to the facilities. See Note 14.
4. RECEIVABLES
Receivables, before the allowance for doubtful accounts, consist of the following components:
The Company provides credit for a substantial portion of its revenues and continually monitors the credit-worthiness and collectibility from its clients, including proper documentation of third-party coverage. The Company is subject to accounting losses from uncollectible receivables in excess of its reserves.
Substantially all receivables are provided as collateral on the Company’s debt and lease obligations.
5.
ASSET IMPAIRMENT AND OTHER CHARGES
The Company has recorded various asset impairment and other charges as presented below:
The Company terminated facility leases for three nursing centers in 2004. The Company incurred lease termination charges of approximately $341,000 in 2004 consisting of the remaining net book value of these facilities, costs of completing the transactions and settlement charges.
6.
PROPERTY AND EQUIPMENT
Property and equipment, at cost, consists of the following:
In August 2005, the Company purchased a 120-bed skilled nursing center in Oak Ridge, Tennessee. The Company had operated this facility since 1990 under an operating lease agreement that was to expire in February 2006. The purchase price, approximately $6.7 million, was financed with a mortgage provided by a commercial finance company. The purchase price was allocated to land, buildings and improvements based on estimated fair values.
Substantially all of the Company’s property and equipment are provided as collateral for debt obligations. The Company capitalizes leasehold improvements which will revert back to the lessor of the property at the expiration or termination of the lease, and depreciates these improvements over the shorter of the remaining lease term or the assets’ estimated useful lives.
7.
SHORT-TERM DEBT
Short-term debt consists of the following:
As of December 31, 2006, the Company’s weighted average interest rate on short term debt was 7.0%.
In connection with the Restructuring Agreement the old Subordinated Promissory Note convertible at the Company’s option was exchanged for a new Subordinated Note, which is not convertible. The new Subordinated Note is in the principal amount of approximately $2.5 million, bears interest at 7% and matures on September 30, 2007. Except for eliminating the conversion feature and including prior accrued interest into the note balance, the terms of the new Subordinated Note are the same as the original Subordinated Promissory Note.
8.
SETTLEMENT PROMISSORY NOTES
Promissory notes were issued during 2005 and 2004 in settlement of certain professional liability claims and other disputes. The majority of these notes were non-interest bearing, and were discounted at 7.5%, which approximated the Company’s borrowing rate, as shown below (in thousands):
9.
LONG-TERM DEBT
Long-term debt consists of the following:
As of December 31, 2006, the Company’s weighted average interest rate on long-term debt was approximately 9.7%.
As described in Note 10, in May 2006, the Company completed the sale of certain assets of eleven assisted living facilities located in North Carolina for a sales price of $11.0 million. Proceeds from this transaction were used to pay transaction costs and repay a portion of the mortgage debt secured by these facilities.
On August 7, 2006, the Company entered into an agreement with its commercial mortgage lender, Capmark Finance Inc. (“Capmark”), for a comprehensive refinancing of the Company’s long term debt. Under the terms of the new agreement, Capmark provided mortgage debt (“Mortgage Loan”) of approximately $22.5 million with a five year maturity and a term note of approximately $8.1 million with a four year maturity (“Term Note”) to refinance the Company’s remaining mortgage and bank term debt.
The proceeds of these new loans were used to retire the existing debt and to fund a $1.1 million renovation of a nursing center that is part of the collateral for the mortgage loans. As of December 31, 2006, the remaining loan proceeds restricted for the nursing center renovation, $864,000, are held in an account controlled by the lender and are classified as “cash restricted for capital expenditures,” a non-current asset, in the accompanying balance sheet. In connection with the comprehensive refinancing, the Company made a payment of approximately $2.6 million to reduce outstanding debt and expensed existing deferred financing costs of $194,000 during 2006. The deferred financing costs written off relate to the debt that was retired and are reflected as debt retirement costs on the income statement.
The Mortgage Loan has a term of five years, with principal and interest payable monthly based on a 25 year amortization. Interest is based on 30 day LIBOR plus a margin of 3.75%. The mortgage loan is secured by seven owned nursing centers, related equipment, and a second lien on the accounts receivable of these facilities. The Term Note is due in four years, and is payable monthly based on a 25 year amortization. The note provides for additional semi-annual payments of $1.0 million each such that the loan will amortize in full in four years. Any proceeds received upon disposition of any assets securing the Term Note must be paid to Capmark to reduce the balance of the Term Note. During 2006, additional principal payments of $1.7 million were made from such proceeds. In addition, $1.5 million of principal payments were made from such proceeds during 2007. Interest is based on 30 day LIBOR plus a margin of 6.25%. The Term Note is secured by an assignment of a Note Receivable taken in the sale of the Company’s Canadian subsidiary, an assignment of the proceeds from certain workers compensation insurance premium refunds, by certain real estate held for sale, by two owned nursing centers, and a second mortgage on the seven nursing centers securing the Mortgage Loan. The Mortgage Loan and the Term Note are cross-collateralized. In connection with these new loans, the Company recorded total deferred loan costs of $844,000.
On March 17, 2006, the Company entered into a two year renewal of its term notes and working capital line of credit agreements with its primary bank lender. These term notes were repaid with proceeds from the refinance transaction on August 7, 2006, as described above. The working capital line of credit remains in place with the bank lender and no amounts are outstanding under it at December 31, 2006.
Scheduled principal payments of long-term debt are as follows:
Approximately $8.5 million Canadian ($6.1 million US) was received at closing, with the balance, $8.0 million Canadian ($5.7 million US), scheduled to be received in annual installments of $600,000 Canadian ($428,000 US) on the anniversary of the closing for the first four years and a final installment of $5.6 million Canadian ($4.0 million US) on the fifth anniversary of closing. The future payments may be accelerated upon the occurrences of certain events. The installment portion of the purchase price is evidenced by a promissory note that has been discounted to estimated fair value and was initially recorded in the accompanying balance sheet at $4.7 million US. The Company received payments of $718,000 and $589,000 in 2006 and 2005, respectively. The note receivable was $5.3 million at December 31, 2006 with $534,000 classified as current.
Effective February 2005, the Company sold two nursing centers in Texas that were operating with low occupancy and experiencing operating losses. The net proceeds from the transactions were approximately $375,000. In periods prior to the sale, the Company had recorded impairment provisions and reduced the property to its estimated realizable value, and no material gain or loss was realized on the transactions.
In November 2004, the Company sold certain assets of its medical supply business, Advocat Distribution Services. The initial sales price was $225,000, with additional consideration based on the results of operations of the business over the two years following the sale. No material gain or loss was realized from the proceeds. A total of $69,000 additional consideration has been received as of December 31, 2006.
In October 2004, the Company sold an assisted living facility in North Carolina that had been closed in 2003. The net proceeds were approximately $60,000 and there was no material gain or loss resulting from the sale.
Proceeds from each of these divestiture transactions were used to pay transaction costs and repay debt. In addition to these divestiture transactions, the Company has terminated leases covering certain nursing centers and assisted living facilities, as further discussed in Note 14. Each of these facilities and businesses constitute components under the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and, accordingly, the Company has reclassified the operations and disposed property of each of these components as discontinued operations for all periods presented in the Company’s consolidated financial statements. The results of discontinued operations do not reflect any allocation of corporate general and administrative expense or any allocation of corporate interest expense.
Assets and liabilities of discontinued operations
Property and equipment of discontinued operations consist of the following:
11.
SHAREHOLDERS’ EQUITY, STOCK PLANS AND PREFERRED STOCK
Shareholders’ Rights Plan
In March 2005, the Company approved an amendment to its shareholders rights plan (the “Plan”), which was originally adopted in 1995. The amendment extends the expiration date of the Plan to March 20, 2010 and changes the exercise price of the rights under the Plan to $15. The Plan is designed to protect the Company’s shareholders from unfair or coercive takeover tactics. The amendment approved in March 2005 extended the term of the plan for an additional five years. The Plan, as previously amended in December 7, 1998, provides for one right with respect to each share of common stock. The rights may be exercised only upon the occurrence of certain triggering events, including the acquisition of, or a tender offer for, 15.0% or more of the Company’s common stock without the Company’s prior approval.
Stock-Based Compensation Plans
Beginning January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based Payment,” using the modified prospective method, in which compensation cost is recognized (a) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date. The Company had no unvested awards granted to employees on the effective date. In March 2005, the United States Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 107 (“SAB 107”), which provides supplemental implementation guidance for SFAS No. 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).
Prior to January 1, 2006, the Company accounted for stock-based compensation using the intrinsic value method as prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, and the related Interpretations (“APB No. 25”). Under APB No. 25, no compensation cost related to stock options was recognized because all options were issued with exercise prices equal to the fair market value at the date of grant. Because the Company elected to use the modified prospective method in adopting the provisions of SFAS No. 123R, results for prior periods have not been restated. Had compensation cost for the Company’s stock-based compensation plans in prior periods been determined consistent with SFAS No. 123R, the Company’s net income for common stock and net income per common share would not have differed from the amounts reported.
In 1994, the Company adopted the 1994 Incentive and Nonqualified Stock Option Plan for Key Personnel (the “Key Personnel Plan”). Under the Key Personnel Plan, as amended in May 1998, 1,060,000 shares of the Company’s common stock have been reserved for issuance upon exercise of options granted thereunder. In 1994, the Company also adopted the 1994 Nonqualified Stock Option Plan for the Directors (the “Director Plan”). Under the Director Plan, as amended in May 1996, 190,000 shares of the Company’s common stock have been reserved for issuance upon exercise of options granted thereunder.
Under both plans, the option exercise price equals the stock’s closing market price on the day prior to the grant date. The maximum term of any option granted pursuant to either the Key Personnel Plan or to the Director Plan is ten years. Options issued under either plan are one-third vested at the grant date with an additional one-third vesting on each of the next two anniversaries of the grant date. Shares subject to options granted under either plan that expire, terminate, or are canceled without having been exercised in full become available again for future grants.
In accordance with their terms, the Key Personnel Plan and the Director Plan expired in May 2004. Accordingly, no further grants can be made under these plans.
In December 2005, the Compensation Committee of the Board of Directors adopted the 2005 Long-Term Incentive Plan (“the 2005 Plan”). The 2005 Plan allows the Company to issue stock options and other share and cash based awards. Under the 2005 Plan, 700,000 shares of the Company’s common stock have been reserved for issuance upon exercise of options granted thereunder.
At the time of adoption, the Board approved the issuance of options to purchase approximately 332,000 shares of the Company’s common stock at a purchase price of $5.44 per share, the market price of the
Company’s common stock on the date the options were authorized. This issuance was subject to shareholder approval of the 2005 Plan which occurred in June 2006 at the Company’s 2006 Annual Shareholders’ Meeting. At the time of shareholder approval, the Company’s stock price had increased to $16.80. Upon shareholder approval, the options for the purchase of approximately 314,000 shares were vested with the remainder vesting one-half each on the next two anniversaries of the date the shares were authorized by the Board of Directors. All options under this plan expire 10 years from the date the shares were authorized by the Board of Directors.
The Company recorded stock-based compensation expense for stock options issued under the 2005 Plan of $5,184,000 during the year ended December 31, 2006. This stock-based compensation expense resulted in an increase to paid-in capital of $5,184,000. As of December 31, 2006, there was $93,000 of total remaining compensation costs related to stock-based compensation to be recognized over the applicable remaining vesting periods. The Company estimated the total recognized and unrecognized compensation using the Black-Scholes-Merton option valuation model.
The table below shows the weighted average assumptions the Company used to develop the fair value estimates under its option valuation model.
In computing the fair value estimates using the Black-Scholes-Merton valuation model, the Company took into consideration the exercise price of the options, $5.44, and the market price of the Company’s stock on the date of shareholder approval, $16.80. The Company used an expected volatility that equals the historical volatility over the most recent period equal to the expected life of the options. The risk free interest rate is based on the U.S. treasury yield curve in effect at the time of grant. The Company used an expected dividend yield of zero since it has not paid cash dividends on its common stock and estimated the options expected term based on the average of the vesting term and the original contractual terms of the grants, consistent with the interpretive guidance in SAB 107.
During the year ending December 31, 2006 approximately 141,000 shares were exercised under these plans generating proceeds of $558,000.
The following table summarizes information regarding stock options outstanding as of December 31, 2006:
As of December 31, 2006, the outstanding options have a weighted average remaining life of 7.2 years.
Summarized activity of the stock option plans is presented below:
Series A Preferred Stock
The Company is authorized to issue up to 200,000 shares of Series A preferred stock. The Company’s Board of Directors is authorized to establish the terms and rights of each series, including the voting powers, designations, preferences, and other special rights, qualifications, limitations, or restrictions thereof.
Series B and Series C Preferred Stock
As part of the consideration paid to Omega for restructuring the terms of the Omega Master Lease in November 2000, the Company issued to Omega 393,658 shares of the Company’s Series B Redeemable Convertible Preferred Stock. The Company’s Series B Redeemable Convertible Preferred Stock had a stated value of $3,300,000 and carried an annual dividend rate of 7% of the stated value. The dividends accrued on a daily basis whether or not declared by the Company and compound quarterly. As discussed in Note 3, under the terms of the Restructuring Agreement, the Series B Redeemable Convertible Preferred Stock (“Series B Preferred Stock”) held by Omega was exchanged for a new Series C Preferred Stock that is not convertible.
At the time of the Restructuring Agreement, the Series B Preferred Stock had a recorded value (including accrued dividends) of approximately $4.9 million, accrued dividends at an annual rate of 7% of the stated value, compounded quarterly, and was convertible into approximately 792,000 shares of common stock.
The Company issued 5,000 shares of Series C Preferred Stock to Omega in exchange for the 393,658 shares of Series B Preferred Stock held by Omega. The new Series C Preferred Stock has a stated value of approximately $4.9 million and carries an annual dividend rate of 7% of its stated value. The Series C Preferred Stock will pay quarterly cash dividends. The Series C Preferred Stock is not convertible, but is redeemable at its stated value at Omega’s option after September 30, 2010, and is redeemable at its stated value at the Company’s option after September 30, 2007, subject to certain limitations. In connection with the termination of the conversion feature, the Company agreed to pay Omega an additional $687,000 annually under the Lease Amendment.
The Company recorded the fair value of the elimination of the conversion feature as a reduction in Paid In Capital with an offsetting increase to record a premium on the Series C Preferred Stock. As a result, the Series C Preferred Stock was initially recorded at a total value of $11.6 million, equal to the stated value
of the Series B Preferred Stock ($4.9 million) plus the negotiated value of the conversion feature, $6.7 million. The additional rental payments of $687,000 annually were discounted over the twelve year term of the renewal so that the net present value of the payments equals the $6.7 million preferred stock premium. When payments are made, the preferred stock premium is reduced, interest expense is recorded and cash is reduced.
During 2006, Advocat declared and paid dividends of $172,000 on the Series B and Series C Preferred Stock.
The Series C Preferred Stock shares have preference in liquidation but do not have voting rights. The total redemption value is equal to the stated value plus any accrued but unpaid dividends. The liquidation preference value is equal to the redemption value.
Information with respect to the calculation of basic and diluted net income ( loss) per common share is presented below:
For 2006, 2005 and 2004, the dilutive effects of the Company’s stock options and Series B Redeemable Convertible Preferred Stock are included in the computation of diluted income per common share for the period of time the Series B Preferred Stock was outstanding. See Notes 3 and 11. Under the applicable provisions of the Internal Revenue Code, Omega, as a Real Estate Investment Trust, is limited in the amount of ownership in the Company it can hold. The terms of the Series B Redeemable Convertible Preferred Stock limit the amount of common stock that Omega may receive on such conversion. The computation of diluted earnings per share reflects the effect of these limitations on the number of common shares issued and the effects of interest expense from the assumed issuance of a promissory note for the balance of preferred shares not converted to common stock.
13.
INCOME TAXES
The provision (benefit) for income taxes of continuing operations is composed of the following components:
A reconciliation of taxes computed at statutory income tax rates on income from continuing operations is as follows:
The net deferred tax assets and liabilities, at the respective income tax rates, are as follows:
The Company has maintained a valuation allowance for its deferred tax assets, as the absence of income in the past, together with the Company’s liquidity and financial position, created uncertainty surrounding the realization of the benefits of the Company’s deferred tax assets in future periods. In 2006 and 2005, the Company recorded a provision for deferred income taxes of approximately $4,834,000 and $4,196,000, respectively, and a decrease in net deferred tax assets. In 2004, the Company utilized valuation allowances of approximately $2,656,000, to offset a corresponding decrease in net deferred tax assets.
In 2006 and 2005, the Company also recorded a deferred tax benefit to reverse approximately $14,553,000 and $18,056,000, respectively, of the valuation allowance on deferred tax assets. During 2006 the Company assessed the valuation allowance on deferred tax assets based on Management’s belief that it is more likely than not that a larger portion of the Company’s net deferred tax assets will be realized due to the Company’s achieved earnings trend and improved liquidity and financial position. The Company considered many factors when assessing the likelihood of future realization of its deferred tax assets including its recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carryforward periods available to the Company, and the comprehensive refinancing of debt in August 2006, as described in Note 9. Prior to the comprehensive refinancing of debt, the Company had net working capital deficits, short-term debt maturities, and was in default of its debt agreements. As a result of the continued improvement in financial results and the completion of the comprehensive refinancing, management believes it has addressed the uncertainties surrounding the realization of the benefits of the Company’s deferred tax assets in future periods.
The Company completed a similar assessment in 2005, and concluded it was more likely than not that some of the Company’s net deferred tax assets will be realized due to the Company’s achieved earnings trend and outlook. However, prior to the completion of the comprehensive refinancing as described above, the uncertainty surrounding the Company’s ability to continue as a going concern impacted management’s assumptions regarding the availability of taxable income in future periods, limiting the amount of net deferred tax assets that could be realized.
The Company continues to maintain a valuation allowance of approximately $904,000 to reduce the deferred tax assets by the amount management believes is more likely not to be utilized through the turnaround of existing temporary differences, future earnings, or a combination thereof. In future periods, the Company will continue to assess the need for and adequacy of the remaining valuation allowance.
The Company received previously undistributed earnings from its Canadian subsidiary in connection with the sale of the subsidiary in 2004, as discussed in Note 10. Deferred income taxes on these undistributed earnings had not been recognized prior to the sale, as they were intended to be permanently reinvested.
At December 31, 2006, the Company had $23,387,000 of net operating losses, which expire at various dates beginning in 2019 and continuing through 2026. During 2005, the Company completed an evaluation of the effect of change in ownership provisions of the Federal tax code on its net operating loss carryforwards, and determined that its net operating losses generated prior to February 2001 are limited by these provisions. At December 31, 2006, losses totaling $11,908,000 are limited by these change in ownership provisions, and their usage is limited to a maximum of approximately $7,042,000. These losses expire beginning in 2019 and continuing through 2021. The Company had provided a full valuation allowance against the net deferred asset related to these operating losses. As of December 31, 2006, the Company has reduced the deferred tax asset and the corresponding valuation allowances by approximately $1,849,000 for net operating loss deductions permanently lost as a result of the change in ownership provisions. At December 31, 2006, the Company had $11,478,000 of net operating losses that are not subject to these limitations, which expire in 2022, 2023 and 2026.
The United States Internal Revenue Code limits the amount of taxable income that may be offset by net operating losses. As a result of these limitations, the Company recorded a current provision for federal income taxes of continuing operations of $19,000 and $202,000 in 2005 and 2004, respectively.
The Canada Customs and Revenue Agency audited the Canadian federal tax return of DCMS, the Company’s Canadian subsidiary sold in 2004 (see Note 10) for the years ended December 31, 2003 and 2002 and proposed certain adjustments to the Company’s tax returns. The adjustments related to the Company’s deductions related to allocation of overhead charges of United States management to DCMS. Under the terms of the sale of DCMS, the Company is liable for any liability that arises from these adjustments. In 2005, the Company recorded a charge for its estimated liability for additional tax, interest and professional fees resulting from these proposed adjustments. The charge is included in discontinued operations.
Lease Commitments
The Company is committed under long-term operating leases with various expiration dates and varying renewal options. Minimum annual rentals, including renewal option periods (exclusive of taxes, insurance, and maintenance costs) under these leases beginning January 1, 2007, are as follows:
Under lease agreements with Omega and others, the Company’s lease payments are subject to periodic annual escalations as described below and in Note 2. Total lease expense for continuing operations was $16,082,000, $15,836,000 and $15,283,000 for 2006, 2005 and 2004, respectively.
Omega Leases
Effective October 1, 2000, the Company entered into a 10-year restructured lease agreement (the “Settlement and Restructuring Agreement”) with Omega that amended the Omega Master Lease. On October 20, 2006, as described in Note 3, the company and Omega also entered into a Third Amendment to Consolidated Amended and Restated Master Lease (“Lease Amendment”) to extend the term of its facilities leased from Omega. All of the accounts receivable, equipment, inventory and other related assets of the facilities leased pursuant to the Omega Master Lease have been pledged as security under the Omega Master Lease and remain so under the Lease Amendment. The initial term of the Omega Master Lease was ten years, expiring September 30, 2010, with a ten-year renewal term at the option of the Company. The amended master lease commenced on October 1, 2006, and extends to September 30, 2018. The Lease Amendment also provides for a renewal option of an additional twelve years. Other than the change in rent associated with the restructuring of the preferred stock described in
Note 3, there was no change in the base rental amounts as a result of the Lease Amendment. Consistent with prior terms, the lease provides for annual increases in lease payments equal to the lesser of two times the increase in the consumer price index or 3 percent. Under generally accepted accounting principles, the Company is required to report these scheduled rent increases on a straight line basis over the 12 year term of the renewal period.
The Omega Master Lease required the Company to fund capital expenditures related to the leased facilities totaling $1,000,000 during the first two years of the initial lease term. The Company is also required to fund annual capital expenditures equal to $325 per licensed bed over the lease term subject to adjustment for increases in the Consumer Price Index. The Company is in compliance with the capital expenditure requirements. Total required capital expenditures during the remaining lease term are $8,636,000. These capital expenditures are being depreciated on a straight-line basis over the initial lease term beginning October 1, 2000.
Upon expiration of the Omega Master Lease or in the event of a default under the Omega Master Lease, the Company is required to transfer all of the leasehold improvements, equipment, furniture and fixtures of the leased facilities to Omega. The assets to be transferred to Omega are being depreciated on a straight-line basis over the lease term beginning October 1, 2000, and will be fully depreciated upon the expiration of the lease.
The 2006 Lease Amendment together with an earlier amendment in 2005 provide financing of up to $10,000,000 to be used to fund renovations to several nursing centers leased from Omega. The initial $5,000,000 in funding obtained from Omega in the 2005 lease amendment has been substantially used to complete renovations during 2006. The annual base rent related to these facilities will be increased to reflect the amount of capital improvements made to the respective facilities. The increase is based on a rate of 10.25% per year of the amount financed under this amendment. The amendments also included provisions to amend certain professional liability insurance requirements of the master lease agreement in order to cure certain defaults under the master lease agreement. As of December 31, 2006, the Company had incurred expenditures of $5,001,000 for these improvements and had received reimbursements totaling $4,699,000 from Omega.
Florida Leases
Effective April 1, 2003, the Company entered into leases for four nursing centers in Florida that had previously been managed by the Company under management contracts. Omega holds mortgages on these properties and the Company makes the lease payments directly to Omega. Through December 31, 2005, the lease provided for additional rent to be imposed based on the profitability of the facilities. The Company evaluated such additional rentals each quarter and recorded additional expense as incurred. Additional rent totaling $412,000 was recorded in 2005. There was no additional rent incurred in 2004.
The term of the leases were extended in December 2005 through February 2010. The lease provides for annual increases equal to the lesser of two times the consumer price index or 3.0% in subsequent years. The amendment eliminated the additional rents imposed based on the profitability of the facilities beginning January 1, 2006. The Company is recording all scheduled rent increases as additional lease expense on a straight-line basis over the remaining lease term. The Company is also required to fund annual capital expenditures equal to $350 per licensed bed over the initial lease term, subject to adjustment for increases in the Consumer Price Index. These required capital expenditures are depreciated on a straight-line basis over the remaining lease term.
Counsel Leases
The Company leased three nursing centers located in Texas from Counsel Corporation (together with its affiliates, “Counsel”) with an initial term of ten years through April 2004 and one ten-year renewal option. At the expiration of the initial term of this lease, the Company declined to exercise the renewal option, but continued to lease these facilities on a month to month basis until December 2004, when Counsel sold the properties. The Company terminated its operations in these facilities and cooperated in an orderly transition to the new owner.
The Company leased five additional facilities in Canada from Counsel with a remaining term expiring in April 2004. The Canadian facilities are also part of the discontinued operations. As discussed in Note 10, the Company sold its Canadian operations in May 2004 and no longer leases the Canadian facilities from Counsel.
Insurance Matters
Professional Liability and Other Liability Insurance
Due to the Company’s past claims experience and increasing cost of claims throughout the long-term care industry, the premiums paid by the Company for professional liability and other liability insurance to cover future periods exceeds the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, the Company has purchased professional liability insurance coverage for its facilities that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. As a result, the Company is effectively self-insured and expects to remain so for the foreseeable future.
The Company has essentially exhausted all general and professional liability insurance available for claims first made during the period from March 9, 2001 through March 9, 2007. For claims made during the period from March 10, 2007 through March 9, 2008, the Company maintains insurance with coverage limits of $100,000 per medical incident and total aggregate policy coverage limits of $500,000.
Reserve for Estimated Self-Insured Professional Liability Claims
Because the Company’s actual liability for existing and anticipated claims will exceed the Company’s limited insurance coverage, the Company has recorded total liabilities for professional liability and other claims of $25.7 million as of December 31, 2006. This accrual includes estimates of liability for incurred but not reported claims, estimates of liability for reported but unresolved claims, actual liabilities related to settlements, including settlements to be paid over time, and estimates of legal costs related to these claims. All losses are projected on an undiscounted basis.
The Company retains a third-party actuarial firm to estimate the appropriate accrual for incurred general and professional liability claims. For current periods, the actuary primarily uses historical data regarding the frequency and cost of claims over a multi-year period and information regarding the number of occupied beds to develop its estimates of the Company’s ultimate professional liability cost for current periods. The actuary estimates the professional liability accrual for older periods by using currently-known information to adjust the initial reserve that was created for that period. On a quarterly basis, the Company obtains reports of its incurred claims and lawsuits from insurers and a third party claims administrator. The actuary uses this information to determine the timing of claims reporting and the development of reserves, and compares the information obtained to its original estimates of liability. Based on the actual claim information obtained and on estimates regarding the number and cost of additional claims anticipated in the future, the reserve estimate for a particular prior period may be revised upward or downward on a quarterly basis. Final determination of our actual liability for claims incurred in any given period is a process that takes years.
The following summarizes the Company’s accrual for professional liability and other claims for each policy year as of the end of the period:
The Company’s cash expenditures for self-insured professional liability costs were $3,361,000, $4,111,000 and $3,286,000 for 2006, 2005 and 2004, respectively.
Although the Company retains a third-party actuarial firm to assist management, professional and general liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. As a result, the Company’s actual liabilities may vary significantly from the accrual, and the amount of the accrual has and may continue to fluctuate by a material amount in any given quarter. Each change in the amount of this accrual will directly affect the Company’s reported earnings and financial position for the period in which the change in accrual is made.
While each quarterly adjustment to the recorded liability for professional liability claims affects reported income, these changes do not directly affect the Company’s cash position because the accrual for these liabilities is not funded. A significant judgment entered against the Company in one or more legal actions could have a material adverse impact on the Company’s financial position and cash flows.
Other Insurance
With respect to workers’ compensation insurance, substantially all of the Company’s employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. The Company is completely self-insured for workers compensation exposures prior to May 1997. The Company has been and remains a non-subscriber to the Texas workers’ compensation system and is, therefore, completely self-insured for employee injuries with respect to its Texas operations. The Company has provided reserves for the settlement of outstanding self-insured claims at amounts believed to be adequate. The liability recorded by the Company for the self-insured obligations under these plans is $474,000 as of December 31, 2006.
Effective June 30, 2003, the Company entered into new workers compensation insurance programs that provide coverage for claims incurred, with premium adjustments depending on incurred losses. The Company accounts for premium expense under these policies based on its estimate of the level of claims expected to be incurred. As of December 31, 2006, the Company has recorded estimated premium refunds due under these programs totaling approximately $3.5 million included in “insurance refunds receivable” in the accompanying balance sheet. Any adjustments of future premiums for workers compensation policies and differences between actual settlements and reserves for self-insured obligations are included in expense in the period finalized.
The Company is self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 per individual annually. The Company provides reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate. The liability for reported claims and estimates for incurred but unreported claims is $932,000 at December 31, 2006. The differences between actual settlements and reserves are included in expense in the period finalized.
Employment Agreements
The Company has employment agreements with certain members of management that provide for the payment to these members of amounts up to 2.5 times their annual salary in the event of a termination without cause, a constructive discharge (as defined), or upon a change in control of the Company (as defined). The maximum contingent liability under these agreements is approximately $1.8 million. The terms of such agreements are from one to three years and automatically renew for one year if not terminated by the employee or the Company. In addition, upon the occurrence of any triggering event, certain executives may elect to require the Company to purchase options granted to them for a purchase price equal to the difference in the fair market value of the Company’s common stock at the date of termination versus the stated option exercise price. Based on the closing price of our common stock on December 31, 2006, the maximum contingent liability for the repurchase of the currently vested options is approximately $2.9 million. No amounts have been accrued for this contingent liability.
Health Care Industry and Legal Proceedings
The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Over the last
several years, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse statutes and regulations as well as laws and regulations governing quality of care issues in the skilled nursing profession in general. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations is subject to ongoing government review and interpretation, as well as regulatory actions which may be unknown or unasserted at this time. The Company is involved in regulatory actions of this type from time to time. Additionally, changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, have had a material adverse effect on the industry and the Company’s financial position, results of operations, and cash flows. Future federal budget legislation and federal and state regulatory changes may negatively impact the Company.
All of the Company’s nursing centers must be licensed by the state in which they are located in order to accept patients, regardless of payor source. In most states, nursing homes are subject to certificate of need laws, which require the Company to obtain government approval for the construction of new nursing homes or the addition of new licensed beds to existing homes. The Company’s nursing centers must comply with detailed statutory and regulatory requirements on an ongoing basis in order to qualify for licensure, as well as for certification as a provider eligible to receive payments from the Medicare and Medicaid programs. Generally, the requirements for licensure and Medicare/Medicaid certification are similar and relate to quality and adequacy of personnel, quality of medical care, record keeping, dietary services, resident rights, and the physical condition of the facility and the adequacy of the equipment used therein. Each facility is subject to periodic inspections, known as “surveys” by health care regulators, to determine compliance with all applicable licensure and certification standards. Such requirements are both subjective and subject to change. If the survey concludes that there are deficiencies in compliance, the facility is subject to various sanctions, including but not limited to monetary fines and penalties, suspension of new admissions, non-payment for new admissions and loss of licensure or certification. Generally, however, once a facility receives written notice of any compliance deficiencies, it may submit a written plan of correction and is given a reasonable opportunity to correct the deficiencies. There can be no assurance that, in the future, the Company will be able to maintain such licenses and certifications for its facilities or that the Company will not be required to expend significant sums in order to comply with regulatory requirements.
As of December 31, 2006, the Company is engaged in 18 professional liability lawsuits. Three of these matters are currently scheduled for trial within the next year. The ultimate results of these or any other of the Company’s professional liability claims and disputes cannot be predicted. The Company has limited, and sometimes no, professional liability insurance with regard to most of these claims. A significant judgment entered against the Company in one or more of these legal actions could have a material adverse impact on the Company’s financial position and cash flows.
In the course of the Company’s business, it is periodically involved in governmental investigations, regulatory and administrative proceedings and lawsuits relating to its compliance with regulations and laws governing its operations, including reimbursement laws, fraud and abuse laws, elderly abuse laws, and state and federal false claims acts and laws governing quality of care issues. A finding of non-compliance with any of these governing laws or regulations in any such lawsuit, regulatory proceeding or investigation could have a material adverse impact on the Company’s financial condition, cash flows or results of operations and could also subject it to fines, penalties and damages. Moreover, the Company could be excluded from the Medicare, Medicaid or other state or federally-funded health care programs, which would also have a material adverse impact on its financial condition, cash flows or results of operations.
Reimbursement
In 2005, the Centers for Medicare and Medicaid Services (“CMS”) issued the final rule for the refinement of the Resource Utilization Group (“RUG”) system and provided for the elimination of the reimbursement add-ons for high acuity patients. In addition, Congress implemented a market basket adjustment of approximately 3.1% designed to increase reimbursement for the effects of inflation. The actual amount of the market basket adjustments is adjusted based on various factors. The market basket adjustment that became effective October 1, 2006 resulted in an average increase of approximately 2.1% for the Company’s facilities as a group, and increased our revenue by approximately $0.1 million per month.
Certain per person annual Medicare Part B reimbursement limits on therapy services became effective January 1, 2006. Subject to certain exceptions, the limits impose a $1,740 per patient annual ceiling on physical and speech therapy services, and a separate $1,740 per patient annual ceiling on occupational therapy services. CMS established an exception process to permit therapy services in certain situations, and the majority of services the Company provided were reimbursed under the exceptions. On December 9, 2006, Congress passed the Tax Relief and Health Care Act of 2006 (TRHCA) which includes an extension of the existing exceptions process through December 31, 2007. If the exception process is discontinued after 2007, it is expected that the reimbursement limitations will reduce therapy revenues and negatively impact the Company’s operating results and cash flows.
The Federal Deficit Reduction Act of 2005 mandates reducing by 30% the amount that Medicare reimburses nursing centers and other non-hospital providers for bad debts arising from uncollectible Medicare coinsurance and deductibles for those individuals that are not dually eligible for Medicare and Medicaid. The reduction is to be phased in over a three year period with 10% during fiscal 2006, 20% during fiscal 2007 and 30% thereafter. This provision is not expected to have a material impact on the Company’s operating results.
The TRHCA passed by Congress on December 9, 2006 reduces the maximum federal matching under Medicare provider assessments to 5.5% of aggregate Medicaid outlays. This reduction in funding will become effective for fiscal years beginning after January 1, 2008. The Congressional action eliminated a regulatory effort proposed by the President’s proposed fiscal year 2007 federal budget to reduce the allowable federal matching share from 6% to 3%. The new law is expected to have an adverse effect in those states where the tax percentage exceeds 5.5%. The budget proposed by President Bush for the government’s 2007 fiscal year includes a number of proposed reductions to Medicare reimbursement for nursing homes and also appears to challenge certain Federal matching programs that benefit many of the state Medicaid programs, including several of the states in which the Company operates. In the event the Federal government reduces the amount of state funding eligible for the Federal matching program, there will be pressure on the states to reduce current reimbursement levels. If the states reduce the Medicaid reimbursement in response to any Federal action, it is expected that the reduction in revenues would have a material effect on the Company’s operating results. The Company is unable to quantify the impact that these possible reimbursement cuts would have on it.
Reduction in health care spending has become a national priority in the United States, and the field of health care regulation and reimbursement is a rapidly evolving one. For the fiscal year ended December 31, 2006, the Company derived 30.5% and 56.5% of its total patient revenues related to continuing operations from the Medicare and Medicaid programs, respectively. Any health care reforms that significantly limit rates of reimbursement under these programs could, therefore, have a material adverse effect on its profitability. The Company is unable to predict which reform proposals or reimbursement limitations will be adopted in the future, or the effect such changes would have on its operations.
The Company will attempt to increase revenues from non-governmental sources to the extent capital is available to do so, if at all. However, private payors, including managed care payors, are increasingly 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, which can result in significant losses to health care providers if patients require expensive treatment not adequately covered by the capitated rate.
The Company commenced operations effective with an initial public offering of common stock in May 1994. The Company’s predecessor operations were in companies owned or controlled by Counsel. From the Company’s inception through November 1996, the Company had two directors who are directors and key executives of Counsel. Until the sale of DCMS, as discussed in Note 10, the Company provided management services for nine facilities owned by two Canadian limited partnerships. Management fees from these facilities totaled $522,000 for 2004, and are included in Income from Discontinued Operations in the accompanying consolidated financial statements. Counsel leased seven of these facilities from one of the partnerships.
The Company leased 8 facilities from Counsel. As discussed in Note 14, following the sale of DCMS and the expiration of leases for facilities in the United States, the Company no longer leases any facilities from Counsel. Lease expense related to the facilities leased from Counsel totaled $590,000 in 2004, and is included in Discontinued Operations in the accompanying consolidated financial statements.
16. QUARTERLY FINANCIAL INFORMATION (Unaudited)
Selected quarterly financial information for each of the quarters in the years ended December 31, 2006 and 2005 is as follows:
(1)
The Company’s quarterly results are significantly affected by the amounts recorded for professional liability expense, as discussed further in Note 14. The amount of expense (benefit) recorded for professional liability in each quarter of 2005 is set forth in the table above.
(2)
Includes $13.9 million deferred tax benefit, as further discussed in Note 13.
(3)
Includes asset impairment and other charges of $4.4 million, as further discussed in Note 5.
ADVOCAT INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
OF CONTINUING OPERATIONS
(in thousands)
(1)
As discussed in Note 10 of the Consolidated Financial Statements, the Company has presented the results of certain divestiture and lease termination transactions as discontinued operations. Apart from the sale of the Canadian operations, the other divestiture and lease termination transactions generally resulted in the surrender of property and equipment in the facilities, but did not result in the sale of accounts receivable or other current assets or the assumption of current liabilities or debt. Accordingly, such current assets and liabilities were not reclassified to discontinued operations. This schedule sets forth amount of provision for doubtful accounts charged to discontinued operations separately for discontinued operations other than the Canadian operations. The amounts related to the Canadian operations are disclosed separately in the next schedule.
S-1
ADVOCAT INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
OF DISCONTINUED CANADIAN OPERATIONS
(in thousands)
(1)
As discussed in Note 10 of the Consolidated Financial Statements, the Company has presented the results of certain divestitures as discontinued operations. The receivables and related allowance for doubtful accounts of the Canadian operations were reclassified to discontinued operations. This schedule sets forth the amounts related solely to Canadian operations.
(2)
The Canadian operations were sold in May 2004, and all related accounts were removed in recording the sale.
S-2