Document


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 FORM 10-Q
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 2018
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission file number: 001-36623
 CIVITAS SOLUTIONS, INC.
(Exact name of registrant as specified in its charter)
Delaware
 
65-1309110
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
313 Congress Street, 6th Floor
Boston, Massachusetts 02210
 
(617) 790-4800
(Address of principal executive offices, including zip code)
 
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  x    No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. 
Large accelerated filer
 
o
  
Accelerated filer
 
x
 
 
 
 
Non-accelerated filer
 
o  (Do not check if smaller reporting company)
  
Smaller reporting company
 
o
 
 
 
 
 
 
 
Emerging growth company

 
o
 
 
 
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  x
As of January 31, 2019, there were 36,307,002 shares outstanding of the registrant’s common stock, $0.01 par value.




TABLE OF CONTENTS
Civitas Solutions, Inc.
 
 
 
Page
 
Condensed Consolidated Balance Sheets as of December 31, 2018 and September 30, 2018
 
Condensed Consolidated Statements of Income for the three months ended December 31, 2018 and 2017
 
 
Condensed Consolidated Statements of Stockholders’ Equity for the three months ended December 31, 2018 and 2017
 
Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2018 and 2017
 
 
 
 
 


2



PART I. FINANCIAL INFORMATION
Item 1.
Condensed Consolidated Financial Statements
Civitas Solutions, Inc.
Condensed Consolidated Balance Sheets
(Amounts in thousands, except share and per share amounts)
(Unaudited) 
 
December 31,
2018
 
September 30,
2018
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
6,805

 
$
8,168

Restricted cash
389

 
333

Accounts receivable, net of allowances of $22,622 and $20,229 at December 31, 2018 and September 30, 2018
173,380

 
186,311

Prepaid expenses and other current assets
19,084

 
18,439

Total current assets
199,658

 
213,251

Property and equipment, net
196,011

 
196,992

Intangible assets, net
306,418

 
317,172

Goodwill
310,499

 
311,752

Restricted cash
50,000

 
50,000

Other assets
36,961

 
38,025

Total assets
$
1,099,547

 
$
1,127,192

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
24,683

 
$
38,669

Accrued payroll and related costs
66,587

 
82,820

Other accrued liabilities
44,982

 
43,864

Obligations under capital lease, current
806

 
781

Current portion of long-term debt
7,331

 
7,331

Total current liabilities
144,389

 
173,465

Other long-term liabilities
81,854

 
79,847

Deferred tax liabilities, net
2,881

 
8,122

Obligations under capital lease, less current portion
10,615

 
10,827

Long-term debt, less current portion
686,918

 
688,197

Commitments and Contingencies (Note 13)

 

Stockholders’ equity
 
 
 
Common stock, $0.01 par value; 350,000,000 shares authorized; and 36,280,500 and 36,116,252 shares issued and outstanding at December 31, 2018 and September 30, 2018, respectively
362

 
360

Additional paid-in capital
287,890

 
286,897

Accumulated gain (loss) on derivatives, net of tax of $1,034 and $1,501 at December 31, 2018 and September 30, 2018, respectively
2,710

 
3,936

Accumulated deficit
(118,072
)
 
(124,459
)
Total stockholders’ equity
172,890

 
166,734

Total liabilities and stockholders’ equity
$
1,099,547

 
$
1,127,192

See accompanying notes to these condensed consolidated financial statements.

3



Civitas Solutions, Inc.
Condensed Consolidated Statements of Income
(Amounts in thousands, except share and per share amounts)
(Unaudited)
 
 
Three Months Ended
December 31,
 
2018
 
2017
Net revenue
$
406,631

 
$
395,418

Cost of revenue
322,352

 
316,257

Operating expenses:
 
 
 
General and administrative
41,032

 
44,534

Depreciation and amortization
22,375

 
21,797

Total operating expenses
63,407

 
66,331

Income from operations
20,872

 
12,830

Other income (expense):
 
 
 
Other income (expense), net
(1,347
)
 
446

Interest expense
(10,166
)
 
(9,009
)
Income before income taxes
9,359

 
4,267

Provision (benefit) for income taxes
2,972

 
(5,127
)
Net income
$
6,387

 
$
9,394

 
 
 
 
Basic and diluted income per common share
$
0.18

 
$
0.25

 
 
 
 
Weighted average number of common shares outstanding, basic
36,162,345

 
37,472,018

Weighted average number of common shares outstanding, diluted
36,378,664

 
37,675,792

See accompanying notes to these condensed consolidated financial statements.


4



Civitas Solutions, Inc.
Condensed Consolidated Statements of Comprehensive Income
(Amounts in thousands)
(Unaudited)
 
 
Three Months Ended
December 31,
 
2018
 
2017
Net income
$
6,387

 
$
9,394

Other comprehensive income, net of tax:
 
 
 
Gain (loss) on derivative instrument classified as cash flow hedge, net of tax of ($467) and $637 for the three months ended December 31, 2018 and 2017, respectively
(1,226
)
 
1,601

Comprehensive income
$
5,161

 
$
10,995

See accompanying notes to these condensed consolidated financial statements.


5



Civitas Solutions, Inc.
Condensed Consolidated Statements of Stockholders’ Equity
(Amounts in thousands, except share amounts)
(Unaudited)

For the three months ended December 31, 2018
 
 
Common Stock
 
Additional
Paid-in
Capital
 
Accumulated
Gain (Loss) on Derivatives
 
Accumulated
Deficit
 
Total
Stockholders’
Equity
 
Shares
 
Amount
 
Balance at September 30, 2018
36,116,252

 
$
360

 
$
286,897

 
$
3,936

 
$
(124,459
)
 
$
166,734

Issuance of common stock under employee incentive plans, net of shares surrendered
164,248

 
2

 
(1,075
)
 

 

 
(1,073
)
Stock-based compensation

 

 
2,068

 

 

 
2,068

Other comprehensive income, net of tax

 

 

 
(1,226
)
 

 
(1,226
)
Net income

 

 

 

 
6,387

 
6,387

Balance at December 31, 2018
36,280,500


$
362


$
287,890


$
2,710


$
(118,072
)

$
172,890



For the three months ended December 31, 2017
 
 
Common Stock
 
Additional
Paid-in
Capital
 
Accumulated
Gain (Loss) on Derivatives
 
Accumulated
Deficit
 
Total
Stockholders’
Equity
 
Shares
 
Amount
 
Balance at September 30, 2017
37,441,257

 
$
374

 
$
301,819

 
$
(91
)
 
$
(139,185
)
 
$
162,917

Cumulative effect adjustment on adoption of ASU 2016-09
 
 
 
 
219

 
 
 
(160
)
 
59

Issuance of common stock under employee incentive plans, net of shares surrendered
105,380

 
1

 
(1,065
)
 

 

 
(1,064
)
Stock-based compensation

 

 
1,651

 

 

 
1,651

Other comprehensive income, net of tax

 

 

 
1,601

 

 
1,601

Net income

 

 

 

 
9,394

 
9,394

Balance at December 31, 2017
37,546,637

 
$
375

 
$
302,624

 
$
1,510

 
$
(129,951
)
 
$
174,558



See accompanying notes to these condensed consolidated financial statements.


6



Civitas Solutions, Inc.
Condensed Consolidated Statements of Cash Flows
(Amounts in thousands)
(Unaudited)
 
Three Months Ended
December 31,
 
2018
 
2017
Operating activities:
 
 
 
Net income
$
6,387

 
$
9,394

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Provision for accounts receivable allowances
6,928

 
4,770

Depreciation and amortization
22,375

 
21,797

Amortization original issue discount and financing costs
553

 
544

Stock-based compensation
2,068

 
1,651

Deferred income taxes
(3,520
)
 
(7,910
)
Loss on disposal of assets
211

 
94

Gain from derivatives

 
(82
)
Changes in operating assets and liabilities, net of acquisitions:
 
 
 
Accounts receivable
6,003

 
2,100

Other assets
(1,274
)
 
(14,664
)
Accounts payable
(11,377
)
 
(150
)
Accrued payroll and related costs
(16,233
)
 
(15,799
)
Other accrued liabilities
1,598

 
2,772

Other long-term liabilities
2,007

 
4,313

Net cash provided by operating activities
15,726

 
8,830

Investing activities:
 
 
 
Acquisition of businesses, net of cash acquired

 
(81,926
)
Purchases of property and equipment
(14,200
)
 
(11,187
)
Proceeds from sale of assets
740

 
1,733

Net cash used in investing activities
(13,460
)
 
(91,380
)
Financing activities:
 
 
 
Proceeds from long term-debt, net of original issue discount

 
74,452

Repayments of long-term debt
(1,833
)
 
(1,833
)
Proceeds from borrowings under senior revolver
27,400

 
66,200

Repayments of borrowings under senior revolver
(27,400
)
 
(61,200
)
Repayments of capital lease obligations
(187
)
 
(146
)
Cash paid for earn out obligations
(480
)
 

Payments of deferred financing costs

 
(258
)
Taxes paid related to net share settlements of equity awards

(1,073
)
 
(1,064
)
Net cash provided by (used in) financing activities
(3,573
)
 
76,151

Net decrease in cash, cash equivalents, and restricted cash
(1,307
)
 
(6,399
)
Cash, cash equivalents, and restricted cash at beginning of period
58,501

 
57,624

Cash, cash equivalents, and restricted cash at end of period
$
57,194

 
$
51,225

 
 
 
 
Reconciliation of cash, cash equivalents, and restricted cash to the condensed consolidated balance sheets
 
 
 
Cash and cash equivalents
$
6,805

 
$

Restricted cash, current
389

 
1,225

Restricted cash, noncurrent
50,000

 
50,000

Total cash, cash equivalents, and restricted cash
$
57,194

 
$
51,225








See accompanying notes to these condensed consolidated financial statements.

7




Civitas Solutions, Inc.
Condensed Consolidated Statements of Cash Flows (continued)
(Amounts in thousands)
(Unaudited)
Supplemental disclosure of cash flow information
 
 
 
Cash paid for interest
$
9,524

 
$
8,201

Cash paid for income taxes
$
3,578

 
$
11,019

Supplemental disclosure of non-cash activities:
 
 
 
Accrued property and equipment
$
1,056

 
$
883

Fair value of contingent consideration related to acquisitions
$

 
$
1,080


See accompanying notes to these condensed consolidated financial statements.

8



Civitas Solutions, Inc.
Notes to Condensed Consolidated Financial Statements
December 31, 2018
(Unaudited)

1. Business Overview
Civitas Solutions, Inc. ("Civitas"), through its wholly-owned subsidiaries (collectively, the "Company"), is the leading provider of home- and community-based health and human services to adults and children with intellectual and/or developmental disabilities, acquired brain injury and other catastrophic injuries and illnesses; and to youth with emotional, behavioral and/or medically complex challenges. Since the Company’s founding in 1980, the Company has evolved into a diversified national network providing an array of high-quality services and care in large, growing and highly-fragmented markets. The Company currently provides services to individuals with intellectual and/or developmental disabilities (“I/DD”), individuals with catastrophic injuries and illnesses, particularly acquired brain injury (“ABI”), youth with emotional, behavioral and/or medically complex challenges, and elders in need of day health services to support their independence. As of December 31, 2018, the Company operated in 36 states, serving approximately 12,700 individuals in residential settings and approximately 18,700 individuals in non-residential settings.
The Company designs customized service plans to meet the individual needs of those served by the Company, which it delivers in home- and community-based settings. Most of the Company’s service plans involve residential support, typically in small group homes, host home settings, or specialized community facilities, designed to improve the quality of life of the individuals served by the Company and to promote their independence and participation in community life. Other services offered include supported living, day and transitional programs, vocational services, case management, family-based and outpatient therapeutic services, post-acute treatment and neurorehabilitation, neurobehavioral rehabilitation and physical, occupational and speech therapies, among others. The Company’s customized service plans offer individuals as well as the payors of these services, an attractive, cost-effective alternative to health and human services provided in large, institutional settings.
Civitas is the parent of a consolidated group of subsidiaries that market their services under The MENTOR Network tradename. NMH Holdings, LLC (“NMHH”) is a wholly owned subsidiary of Civitas and National Mentor Holdings, Inc. (“NMHI”) is a wholly owned subsidiary of NMHH. The financial results of Civitas are primarily composed of the financial results of NMHI and its subsidiaries on a consolidated basis.
We have four operating divisions, Community Support Services ("CSS"), Specialty Rehabilitation Services (“SRS”), Children & Family Services ("CFS") and Adult Day Health ("ADH"). Each operating division represents a reportable segment except ADH which is included within Corporate and Other because it does not meet the thresholds for separate reporting. As of October 1, 2018, Community Support Services and Children & Family Services are new names for the operating divisions formerly referred to as Intellectual and Developmental Disabilities ("I/DD") and At-Risk Youth ("ARY"), respectively. There were no changes to the composition of the operating divisions as a result of these name changes.

2. Merger Agreement

On December 18, 2018, the Company announced that it entered into a definitive merger agreement to be acquired by funds advised by Centerbridge Partners, L.P. The Agreement and Plan of Merger (the “Merger Agreement”), dated as of December 18, 2018, is by and among Celtic Intermediate Corp., a Delaware corporation (“Parent”), Celtic Tier II Corp., a Delaware corporation (“Merger Sub”), and the Company, providing for the merger of Merger Sub with and into the Company (the “Merger”), with the Company (the “Surviving Corporation”) surviving the Merger as a wholly owned subsidiary of Parent.
If the Merger is completed, each share of Civitas common stock issued and outstanding immediately prior to the effective time (other than (i) shares of Civitas common stock owned by the Company (excluding any shares of Civitas common stock owned by any subsidiary of the Company, which will remain outstanding), Parent or Merger Sub and (ii) shares as to which appraisal rights have been properly demanded and perfected in accordance with Section 262 of the General Corporation Law of the State of Delaware) will be automatically cancelled and converted into the right to receive $17.75 in cash, without interest and subject to any applicable withholding taxes.

Pursuant to the Merger Agreement, Civitas equity awards outstanding immediately prior to the effective time of the Merger (the “effective time”) will generally be subject to the following treatment, unless otherwise agreed to by the parties:


9



Each option for a share of Civitas common stock (a “stock option”) whether vested or unvested, will be cancelled and converted into and will become a right to receive an amount in cash, without interest, equal to (1) $17.75 (less the exercise price per share attributable to such stock option); multiplied by (2) the total number of shares of Civitas common stock issuable upon exercise in full of such stock option. On December 7, 2018, as part of its routine annual compensation review cycle, the Board of Directors, at the recommendation of the Compensation Committee, made customary annual equity awards to employees of stock options (the “Annual 2019 Option Awards”), time-based restricted stock units (the “Annual 2019 RSUs”) and performance-based restricted stock units (the “Annual 2019 PRSUs”). The consideration for stock options other than the Annual 2019 Option Awards will be payable on the closing date of the Merger (the “closing date”) and the consideration for the Annual 2019 Option Awards will vest and be payable at the same time as such stock option would have vested pursuant to its terms, subject to the holder’s continued service with Parent or an affiliate of Parent (including the Surviving Corporation or its subsidiary) through the applicable vesting dates. Stock Options with an exercise price per share greater than $17.75 will be cancelled without any cash payment.

Each time-based restricted stock unit (a “RSU”), whether vested or unvested, will be cancelled and will become a right to receive an amount in cash, without interest, equal to (1) $17.75 multiplied by (2) the total number of shares of Civitas common stock subject to such RSU. For each RSU, other than Annual 2019 RSUs, 50% of the consideration for such RSU will be payable on the closing date and the remaining 50% will generally vest and be payable in accordance with the terms of the RSU, subject to the holder’s continued service with Parent or an affiliate of Parent (including the Surviving Corporation or its subsidiary) through the applicable vesting dates (or, if earlier than the applicable vesting dates, the amounts will generally be paid in two equal installments on the first and second anniversaries of the closing date, subject to continued service). For each Annual 2019 RSU, the consideration for such RSU will, subject to the holder’s continued service with Parent or an affiliate of Parent (including the Surviving Corporation or its subsidiary) through the applicable vesting dates, vest and be payable in accordance with the terms of such RSU, with no less than 50% vesting and payable on the first anniversary of the closing date and any remaining unvested portion vesting and payable on the second anniversary of the closing date.

Performance-based restricted stock units (“PRSUs”) granted prior to December 8, 2017 that are outstanding immediately prior to the effective time, whether vested or unvested, will be cancelled for no consideration, PRSUs granted on December 8, 2017 or March 9, 2018 outstanding immediately prior to the effective time, whether vested or unvested, will be cancelled and will become a right to receive an amount in cash, without interest, equal to (x) $17.75 multiplied by (y) the total number of shares of Civitas common stock subject to such PRSU, with any performance-based vesting conditions deemed achieved based on actual performance during the applicable performance period, which shall be shortened to end on the date immediately prior to the closing date, and which amount will be paid on the closing date, and Annual 2019 PRSUs outstanding immediately prior to the effective time, whether vested or unvested, will be cancelled and will become a right to receive an amount in cash, without interest, equal to (x) $17.75 multiplied by (y) the total number of shares of Civitas common stock subject to such PRSU, with any performance-based vesting conditions deemed achieved at target. The consideration in respect of Annual 2019 PRSUs will be subject to the same payment terms, conditions and schedule as for the Annual 2019 RSUs (as described in the immediately preceding paragraph).

The consummation of the Merger is subject to certain customary conditions, including, but not limited to (1) receipt of the vote in favor of the adoption of the Merger Agreement by a the holders of a majority of the outstanding shares of Civitas common stock entitled to vote on the Merger Agreement; (2) expiration of waiting periods (and any extensions thereof), if any, applicable to the consummation of the Merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, (3) the absence of a material adverse effect and (4) the absence of any law or order prohibiting, making illegal or enjoining the Merger.

The Merger Agreement contains certain termination rights, including the right of Civitas to terminate the Merger Agreement to accept a superior proposal, subject to specified conditions and limitations, and the right of either party to terminate the Merger Agreement if the Merger is not consummated by May 17, 2019. Upon termination of the Merger Agreement by Civitas or Parent upon specified conditions, Civitas will be required to pay Parent a termination fee of $20 million, and upon termination of the Merger Agreement by Civitas or Parent under other specified conditions, Parent will be required to pay Civitas a termination fee of $40 million.

In connection with entering into the Merger Agreement, Parent and certain affiliates of Vestar Capital Partners, which collectively owned approximately 54% of the outstanding shares of Civitas common stock as of December 17, 2018, entered into a Voting Agreement (the “Voting Agreement”), pursuant to which such stockholders committed to vote their Civitas common stock in favor of, and take certain other actions in furtherance of, the transactions contemplated by the Merger Agreement, including the Merger. The Voting Agreement will terminate upon the earliest to occur of (1) the effective time, (2) the termination of the Merger Agreement in accordance with its terms, (3) an agreement to terminate the Voting Agreement, or (4) a change of recommendation by the Board of Directors pursuant to the Merger Agreement.

10




During the three months ended December 31, 2018, Civitas recognized approximately $1.2 million of costs in connection with the proposed Merger. These costs are included in general and administrative expenses in the consolidated statements of income.
3. Significant Accounting Policies
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the applicable rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The unaudited condensed consolidated financial statements herein should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2018, which is on file with the SEC. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting of normal and recurring adjustments, necessary to present fairly the financial statements in accordance with GAAP. Intercompany balances and transactions between the Company and its subsidiaries have been eliminated in consolidation. Operating results for the three months ended December 31, 2018 may not necessarily be indicative of results to be expected for any other interim period or for the full year.
The preparation of financial statements in conformity with GAAP 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 revenue and expenses during the reporting period. Actual results could differ from those estimates.
Adoption of New Accounting Pronouncements
Revenue from Contracts with Customers— In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2014-09, Revenue from Contracts with Customers Topic, and has since issued several additional amendments thereto (collectively known as ASC 606). ASC 606 supersedes nearly all existing revenue recognition guidance under U.S. GAAP. On October 1, 2018 the Company adopted ASC 606 using the modified retrospective transition method. Under this method, the reported results for fiscal 2019 reflect the application of ASC 606, while the reported results for fiscal 2018 were prepared under the guidance of ASC 605, Revenue Recognition. The modified retrospective method requires the cumulative effect of applying the new guidance to all contracts with customers that were not completed as of October 1, 2018 to be recorded as an adjustment to retained earnings as of the adoption date. The Company did not record a cumulative effect adjustment to retained earnings as a result of the adoption of ASC 606 because the timing and measurement of revenue for the Company’s contracts with customers has no impact on retained earnings. See Note 11, Revenue Recognition for additional disclosures.
Statement of Cash Flows— In November 2016, the FASB issued ASU No. 2016-18—Statement of Cash Flows (Topic 230): Restricted Cash, which requires that a statement of cash flows present the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The Company adopted the new standard effective October 1, 2018, using the retrospective transition method. The adoption of this new standard resulted in a decrease to Net cash used in investing activities of $0.9 million for the three months ended December 31, 2017.
4. Recent Accounting Pronouncements
Leases— In February 2016, the FASB issued ASU No. 2016-02—Leases (Topic 842). The new standard requires that all lessees recognize the assets and liabilities that arise from leases on the balance sheet and disclose qualitative and quantitative information about its leasing arrangements. The standard will be effective for the Company on October 1, 2019. In July 2018, the FASB issued ASU No. 2018-11—Leases (Topic 842): Targeted Improvements (ASU 2018-11). Prior to ASU 2018-11, a modified retrospective transition was required for financing or operating leases existing at or entered into after the beginning of the earliest comparative period presented in the financial statements. ASU 2018-11 allows entities an additional transition method to the existing requirements whereby an entity could adopt the provisions of ASU 2016-02 by recognizing a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption without adjustment to the

11



financial statements for periods prior to adoption. The Company will elect this new transition method when it adopts ASU 2016-02 on October 1, 2019. The adoption of this standard is expected to have a material impact on the Company's financial position. As of December 31, 2018, the Company had gross operating lease commitments of approximately $351 million. Upon adoption, a substantial portion of these lease commitments will be recorded at their net present value as a right of use asset and a lease obligation.
    
Fair Value Measurements— In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820) - Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement, which is designed to improve the effectiveness of disclosures by removing, modifying and adding disclosures related to fair value measurements. The update is effective for the Company on October 1, 2020, with early adoption permitted. The Company is currently assessing the impact this update will have on its consolidated financial statements.

Cloud Computing Arrangements— In August 2018, the FASB issued ASU 2018-15, Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. The amendments in this update align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). The accounting for the service element of a hosting arrangement that is a service contract is not affected by the amendments in this update. The amendments in this update are effective for the Company on October 1, 2020, with early adoption permitted. The amendments in this update should be applied either retrospectively or prospectively to all implementation costs incurred after the date of adoption. The Company is in the process of assessing the impact of the amendments in this update but does not expect it to have a material impact on the Company's consolidated financial statements.
5. Long-Term Debt
As of December 31, 2018 and September 30, 2018, the Company’s long-term debt consisted of the following:
(in thousands)
December 31,
2018
 
September 30,
2018
Term loan principal; principal and interest are due in quarterly installments through January 31, 2021
$
698,312

 
$
700,145

Original issue discount on term loan, net of accumulated amortization
(909
)
 
(1,020
)
Deferred financing costs, net of accumulated amortization
(3,154
)
 
(3,597
)
 
694,249

 
695,528

Less current portion of the term loan
7,331

 
7,331

Long-term debt
$
686,918

 
$
688,197

Senior Secured Credit Facilities

NMHI's senior credit agreement (the “senior credit agreement”), as amended, governs a $730.0 million Tranche B term loan facility (the “term loan facility”), of which $50.0 million was deposited in a cash collateral account in support of the issuance of letters of credit under an institutional letter of credit facility (the “institutional letter of credit facility”), and a $160.0 million senior secured revolving credit facility (the “senior revolver”). The term loan facility matures on January 31, 2021, $70.0 million of the commitments under the senior revolver matures on January 31, 2019 and $90.0 million of the commitments under the senior revolver matures on January 31, 2021. All of the obligations under the senior secured credit facilities are guaranteed by NMHH and the subsidiary guarantors named therein. The senior credit agreement provides that NMHI may make one or more offers to the lenders, and consummate transactions with individual lenders that accept the terms contained in such offers, to extend the maturity date of the lender’s term loans and/or revolving commitments, subject to certain conditions, and any extended term loans or revolving commitments will constitute a separate class of term loans or revolving commitments.
    
The senior revolver includes borrowing capacity available for letters of credit and for borrowings on same-day notice, referred to as the “swingline loans.” Any issuance of letters of credit or borrowing on a swingline loan will reduce the amount available under the senior revolver. As of December 31, 2018, NMHI had $698.3 million of borrowings outstanding under the term loan facility, no borrowings outstanding under the senior revolver, $48.5 million of letters of credit issued under the institutional letter of credit facility and $1.0 million of standby letters of credit under the senior revolver.
Borrowings under the term loan facility bear interest, at our option, at: (i) an alternate base rate ("ABR") equal to the greater of (a) the prime rate of Barclays Bank PLC, (b) the federal funds rate plus 1/2 of 1.0%, and (c) the Eurodollar rate for

12



an interest period of one-month plus 100 basis points (provided that the ABR applicable to the term loan facility will not be less than 2.00% per annum), plus 2.00%; or (ii) the Eurodollar rate (provided that the Eurodollar rate applicable to the term loan facility will not be less than 0.75% per annum), plus 3.00%. Borrowings under the revolving and swingline loans bear interest at our option at (i) an ABR equal to the greater of (a) the prime rate of Barclays Bank PLC, (b) the federal funds rate plus 1/2 of 1.0%, and (c) the Eurodollar rate for an interest period of one-month plus 100 basis points (provided that the ABR applicable to the term loan facility will not be less than 2.00% per annum), plus 2.25%; or (ii) the Eurodollar rate (provided that the Eurodollar rate applicable to the term loan facility will not be less than 0.75% per annum), plus 3.25%. NMHI is also required to pay a commitment fee to the lenders under the senior revolver at an initial rate of 0.50% of the average daily unutilized commitments thereunder. NMHI must also pay customary letter of credit fees.
The senior credit agreement requires NMHI to make mandatory prepayments, subject to certain exceptions, on a percentage of NMHI's annual Excess Cash Flow, as defined in the senior credit agreement. NMHI determines whether or not a mandatory prepayment is required at the end of each fiscal year. NMHI was not required to make a prepayment for the fiscal year ended September 30, 2018.
Covenants
The senior credit agreement contains negative covenants, including, among other things, limitations on the Company’s ability to incur additional debt, create liens on assets, transfer or sell assets, pay dividends, redeem stock or make other distributions or investments, and engage in certain transactions with affiliates. The senior credit agreement contains a springing financial covenant. If, at the end of any fiscal quarter, the Company’s outstanding borrowings under the senior revolver exceeds 30% of the commitments thereunder, it is required to maintain at the end of each such fiscal quarter a consolidated first lien leverage ratio of not more than 5.00 to 1.00. The springing financial covenant was not in effect as of December 31, 2018 or September 30, 2018 as the Company’s usage of the senior revolver did not exceed the threshold for that quarter.
Derivatives
    
On January 20, 2015, NMHI entered into two interest rate swap agreements in an aggregate notional amount of $375.0 million in order to reduce the variability of cash flows of the Company’s variable rate debt. NMHI entered into these interest rate swaps to hedge the risk of changes in the floating rate of interest on borrowings under the term loan. Under the terms of the swaps, NMHI will receive from the counterparty a quarterly payment based on a rate equal to the greater of 3-month LIBOR or 1.00% per annum, and NMHI will make payments to the counterparty based on a fixed rate of 1.795% per annum, in each case on the notional amount of $375.0 million, settled on a net payment basis. The swap agreements expire on March 31, 2020.

The fair value of the swap agreements, which represents the price that would be received to transfer the agreement in an orderly transaction between market participants, was an asset of $4.1 million and $5.8 million as of December 31, 2018 and September 30, 2018, respectively. Based on the timing of the associated cash flows, the fair value was split between current and long-term classification on the Company’s consolidated balance sheet in Prepaid expenses and other current assets and Other assets as of December 31, 2018 and September 30, 2018. The fair value was determined based on pricing models and independent formulas using current assumptions. Hedge ineffectiveness, if any, associated with the swap is recorded as interest expense in the period incurred. There was no hedge ineffectiveness recorded during the three months ended December 31, 2018. During the three months ended December 31, 2017, the ineffective portion of gains resulting from changes in fair value was $0.1 million which was recorded in Other income (expense), net. No amounts were excluded from ineffectiveness testing for the three months ended December 31, 2018 and 2017.

6. Stock-Based Compensation


13



Stock Options

Stock option activity for the three months ended December 31, 2018 is presented below:
(in thousands, except share and per share amounts)
Number of
Shares
 
Weighted-
Average
Exercise Price
per Share
 
Weighted-
Average
Remaining Life
(Years)
 
Aggregate
Intrinsic
Value (in thousands)
Outstanding at September 30, 2018
939,213

 
$
18.67

 
 
 
 
Granted
177,832

 
13.65

 
 
 
 
Forfeited
8,826

 
18.33

 
 
 
 
Outstanding at December 31, 2018
1,108,219

 
$
17.87

 
7.5
 
$
1,044

Exercisable at December 31, 2018
739,123

 
$
18.85

 
6.7
 
$
289

Vested or expected to vest as of December 31, 2018
1,108,219

 
$
17.87

 
7.5
 
$
1,044


The Company utilizes the Black-Scholes valuation model for estimating the fair value of stock options. Options granted under the 2014 Plan during the three months ended December 31, 2018 were valued using the following assumptions:
 
2018
Risk-free interest rate
2.78%

Expected term
6 years

Expected volatility
36.13%

Expected dividend yield
%

The Company recognizes the fair value of the stock option awards as stock-based compensation expense over the requisite service period of the individual grantee, which equals the vesting period. There were no stock options exercised during the three months ended December 31, 2018. As of December 31, 2018, there was $2.1 million of unrecognized compensation cost related to unvested stock options. This cost is expected to be recognized over a weighted-average period of 2.1 years.

Restricted Stock Unit Awards (RSUs)

Restricted stock unit activity for the three months ended December 31, 2018 is presented below:
 
Number of
Restricted Stock Units
 
Weighted Average
Grant-Date Fair Value
Non-vested units at September 30, 2018
835,899

 
$
18.35

Granted
465,504

 
13.65

Forfeited
29,190

 
18.86

Vested
243,044

 
19.69

Non-vested units at December 31, 2018
1,029,169

 
$
15.90


The fair value of each restricted stock unit was determined based on the Company's closing stock price on the date of grant. The Company recognizes the fair value of the RSUs as stock-based compensation expense over the requisite service period of the individual grantee, which equals the vesting period. The total fair values of RSUs that vested during the three months ended December 31, 2018 was $3.3 million. As of December 31, 2018, there was $13.6 million of unrecognized compensation expense related to unvested restricted stock unit awards. This cost is expected to be recognized over a weighted-average period of 2.3 years.

Performance Based Restricted Stock Units (PRSUs)
    
During the three months ended December 31, 2018, the Company awarded 62,500 PRSUs. These PRSUs vest based upon the achievement of established performance targets over the three year performance period which ends September 30, 2021. The number of PRSUs that may vest varies between 0%200% based on the achievement of such goals. The PRSUs were valued at $13.65 per share based on the closing price of the Company’s common stock on the date of grant.


14



To calculate compensation expense, the Company forecasts the likelihood of achieving the predefined performance targets and calculates the number of PRSUs expected to be earned. As of December 31, 2018, the Company expects to recognize $1.4 million of stock-based compensation expense related to outstanding PRSUs based on the expected attainment levels. This cost is expected to be recognized over a weighted-average period of 2.3 years.

The PRSUs that were granted in fiscal 2016 failed to achieve the minimum threshold of the predetermined performance condition based on the three-year performance period ended on September 30, 2018. As a result, no shares were issued for these awards.
    
A summary of PRSU activity for the three months ended December 31, 2018 is as follows:
 
Number of Performance Based Restricted Stock Units
 
Weighted Average
Grant-Date Fair Value
Non-vested units at September 30, 2018
135,339

 
$
19.44

Granted
62,500

 
13.65

Forfeited
46,663

 
19.79

Non-vested units at December 31, 2018
151,176

 
$
16.94

Units expected to vest as of December 31, 2018
110,291

 
$
15.86

    
Stock-based Compensation Expense
 
The Company recorded stock-based compensation expense for stock options, RSUs and PRSUs under the 2014 Plan of $2.1 million and $1.7 million during the three months ended December 31, 2018 and 2017, respectively. Stock-based compensation expense is included in general and administrative expenses in the consolidated statements of income.

For a discussion of the treatment of the stock options, RSUs and PRSUs in the proposed Merger, see Note 2, Merger Agreement.
7. Goodwill and Intangible Assets
Goodwill
The changes in goodwill for the three months ended December 31, 2018 are as follows (in thousands):
 
CSS
 
SRS
 
CFS
 
Corporate and Other
 
Total
Balance as of September 30, 2018
$
161,718

 
$
117,445

 
$
28,484

 
$
4,105

 
$
311,752

Adjustments to prior acquisitions (1)

 
(1,253
)
 

 

 
(1,253
)
Balance as of December 31, 2018
$
161,718

 
$
116,192

 
$
28,484

 
$
4,105

 
$
310,499

 

(1) Adjustments are the result of finalizing the valuation of intangible assets associated with the acquisition of Mentis Neuro Rehabilitation, LLC (“Mentis”) that was completed during fiscal 2018.

15



Intangible Assets
Intangible assets consist of the following as of December 31, 2018 (in thousands):
Description
Weighted
Average
Amortization Period
 
Gross
Carrying
Value
 
Accumulated
Amortization
 
Intangible
Assets,
Net
Agency contracts
6 years

 
$
581,222

 
$
336,637

 
$
244,585

Non-compete/non-solicit agreements
1 year

 
7,453

 
6,154

 
1,299

Trade names
1 year

 
8,161

 
6,921

 
1,240

Trade names (indefinite life)

 
42,400

 

 
42,400

Licenses and permits
3 years

 
62,279

 
45,385

 
16,894

 
 
 
$
701,515

 
$
395,097

 
$
306,418

Intangible assets consist of the following as of September 30, 2018 (in thousands):
Description
Weighted
Average
Amortization Period
 
Gross
Carrying
Value
 
Accumulated
Amortization
 
Intangible
Assets,
Net
Agency contracts
6 years

 
$
581,222

 
$
326,925

 
$
254,297

Non-compete/non-solicit agreements
1 year

 
7,453

 
5,974

 
1,479

Trade names
1 year

 
8,161

 
6,771

 
1,390

Trade names (indefinite life)

 
42,400

 

 
42,400

Licenses and permits
3 years

 
62,279

 
44,673

 
17,606

 
 
 
$
701,515

 
$
384,343

 
$
317,172

Amortization expense was $10.8 million and $11.4 million for the three months ended December 31, 2018 and 2017, respectively.
The estimated remaining amortization expense related to intangible assets with finite lives for the nine months remaining in fiscal 2019 and each of the four succeeding years and thereafter is as follows:
Year Ended September 30,
(in thousands)
2019
$
33,267

2020
42,580

2021
39,165

2022
37,360

2023
33,019

Thereafter
78,627

Total
$
264,018

8. Fair Value Measurements
The Company measures and reports its financial assets and liabilities on the basis of fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.
A three-level hierarchy for disclosure has been established to show the extent and level of judgment used to estimate fair value measurements, as follows:
Level 1: Quoted market prices in active markets for identical assets or liabilities.
Level 2: Significant other observable inputs (quoted prices in active markets for similar assets or liabilities, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability).

16



Level 3: Significant unobservable inputs for the asset or liability. These values are generally determined using pricing models which utilize management estimates of market participant assumptions.
Valuation techniques for assets and liabilities measured using Level 3 inputs may include methodologies such as the market approach, the income approach or the cost approach, and may use unobservable inputs such as projections, estimates and management’s interpretation of current market data. These unobservable inputs are only utilized to the extent that observable inputs are not available or cost-effective to obtain.
A description of the valuation methodologies used for instruments measured at fair value as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.
The following table sets forth the Company’s assets and liabilities that were accounted for at fair value on a recurring basis as of December 31, 2018.
(in thousands)
Total
 
Quoted
Market Prices
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Assets
 
 
 
 
 
 
 
Interest rate swap agreements (current)
$
3,338

 
$

 
$
3,338

 
$

Interest rate swap agreements (long-term)
736

 

 
736

 

Total
$
4,074

 
$

 
$
4,074

 
$

Liabilities
 
 
 
 
 
 
 
Contingent consideration
$
1,325

 
$

 
$

 
$
1,325

The following table sets forth the Company’s assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2018.
(in thousands)
Total
 
Quoted
Market Prices
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Assets
 
 
 
 
 
 
 
Interest rate swap agreements (current)
$
3,447

 
$

 
$
3,447

 
$

Interest rate swap agreements (long-term)
2,320

 

 
2,320

 

Total
$
5,767

 
$

 
$
5,767

 
$

Liabilities
 
 
 
 
 
 
 
Contingent consideration
$
1,805

 
$

 
$

 
$
1,805


Interest rate-swap agreements. The Company’s interest rate-swap agreements are classified within Level 2 of the fair value hierarchy. Based on the timing of the associated cash flows, the fair value of the swap agreements was recorded in Prepaid expenses and other current assets or Other assets in the Company’s condensed consolidated balance sheets. The fair value of these agreements was determined based on pricing models and independent formulas using current assumptions that included swap terms, interest rates and forward LIBOR curves and the Company’s credit risk.
The following table presents a summary of changes in fair value of the Company’s Level 3 liabilities (acquisition related contingent consideration) measured on a recurring basis for the three months ended December 31, 2018.
(in thousands)
Three Months Ended December 31, 2018
Balance at September 30, 2018
$
1,805

Payments (1)
(480
)
Balance at December 31, 2018
$
1,325

(1) The Company settled the contingent consideration obligation associated with the Jac-Lin Manor, Inc acquisition during the three months ended December 31, 2018.
The following table presents a summary of changes in fair value of the Company’s Level 3 liabilities (acquisition related contingent consideration) measured on a recurring basis for the three months ended December 31, 2017.

17



(in thousands)
Three Months Ended
December 31, 2017
Balance at September 30, 2017
$

Acquisition date fair value of contingent consideration obligations recorded
1,080

Balance at December 31, 2017
$
1,080


As of December 31, 2018 and September 30, 2018, the Company had $1.3 million and $1.8 million of contingent consideration liabilities, respectively, which were reflected in Other accrued liabilities or Other long-term liabilities.

At December 31, 2018 and September 30, 2018, the carrying values of cash, accounts receivable, accounts payable and variable rate debt approximated fair value.
9. Income Taxes
The Company’s effective income tax rate for the interim periods is based on management’s estimate of the Company’s annual effective tax rate for the applicable year. It is also affected by discrete items that may occur in any given period. The rates differ from the federal statutory income tax rate primarily due to state income taxes and nondeductible permanent differences such as meals and nondeductible compensation. For the three months ended December 31, 2018, the Company had a provision for income taxes of $3.0 million, or a 31.8% effective income tax rate compared to a benefit from income taxes of $5.1 million, or a (120.2)% effective income tax rate for the three months ended December 31, 2017. The benefit from income taxes for the three months ended December 31, 2017 was primarily due to revaluing of the Company’s deferred tax liabilities as a result of the lower corporate tax rate established by the Tax Cuts and Jobs Act (the “Tax Act”) enacted in the first quarter of fiscal 2018.
The Company files a federal consolidated return and files various state income tax returns and, generally, is no longer subject to income tax examinations by the taxing authorities for years prior to September 30, 2015. The Company did not have a reserve for uncertain income tax positions at December 31, 2018 and September 30, 2018. The Company does not expect any significant changes to unrecognized tax benefits within the next twelve months. The Company’s policy is to recognize interest and penalties related to unrecognized tax benefits as charges to income tax expense.
10. Segment Information

The Company conducts its business through three reportable business segments: the CSS segment, the SRS segment, and the CFS segment.

The Company evaluates performance based on EBITDA. EBITDA for each segment is defined as income (loss) from continuing operations for the segment before income taxes, depreciation and amortization, and interest income (expense).

Activities classified as “Corporate and Other” in the table below relate to the results of the ADH operating segment and unallocated home office expenses and stock-compensation expense. Total assets included in the Corporate and Other segment include assets associated with our ADH operating segment and assets maintained by our corporate entity including cash, restricted cash, and other current and non-current assets.

18



The following table is a financial summary by reportable segments for the periods indicated (in thousands):
For the three months ended December 31,
CSS
 
SRS
 
CFS
 
Corporate and Other
 
Consolidated
2018
 
 
 
 
 
 
 
 
 
Net revenue
$
260,532

 
$
89,103

 
$
38,023

 
$
18,973

 
$
406,631

EBITDA
35,561

 
15,999

 
6,449

 
(16,109
)
 
41,900

Total assets
486,960

 
324,719

 
66,634

 
221,234

 
1,099,547

Depreciation and amortization
10,599

 
7,356

 
1,391

 
3,029

 
22,375

Purchases of property and equipment
6,780

 
2,924

 
488

 
4,008

 
14,200

2017
 
 
 
 
 
 
 
 
 
Net revenue
$
255,891

 
$
85,989

 
$
35,875

 
$
17,663

 
$
395,418

EBITDA
32,976

 
13,624

 
4,812

 
(16,422
)
 
34,990

Depreciation and amortization
10,125

 
6,753

 
1,414

 
3,505

 
21,797

Purchases of property and equipment
7,032

 
2,141

 
299

 
1,715

 
11,187


A reconciliation of EBITDA to income before income taxes on a consolidated basis is as follows (in thousands):
 
For the three months ended December 31,
 
2018
 
2017
EBITDA
$
41,900

 
$
34,990

Less:
 
 
 
Depreciation and amortization
22,375

 
21,797

Interest expense, net 
10,166

 
8,926

Income before income taxes
$
9,359

 
$
4,267


11. Revenue Recognition

On October 1, 2018, the Company adopted Accounting Standard Codification (“ASC”) Topic 606, “Revenue from Contracts with Customers” (“ASC 606”) and all of the related amendments (the “New Revenue Standard”). The New Revenue Standard requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The Company adopted the standard using the modified retrospective approach and did not record a cumulative catch-up adjustment as the timing and measurement of revenue for the Company’s customers is similar to its prior revenue recognition model. The Company’s accounting policies under the New Revenue Standard were applied prospectively to the 2019 fiscal period and are described below.
    
The Company’s net revenue is generated from providing services directly to the individuals we support under contracts with state and local government agencies and non-public payors including commercial insurers and private consumers. Generally, these contracts establish the terms of the customer relationship and set the broad range of terms for services to be performed at a stated rate. However, the contracts do not give rise to rights and obligations until the Company is engaged to provide services by the state or local government agency or the individual being served. When the services are authorized, it creates a performance obligation to provide services over a defined period of time that can range from one day to multiple months. The types of service offerings vary by individual, however; these offerings are not distinct within the context of the contract because the intent is to coordinate the comprehensive care required for an individual. The Company satisfies its performance obligations over time, given that individuals simultaneously receive and consume the benefits provided by the Company as the services are performed. As the Company has the right to consideration from customers commensurate with the value of the services provided to customers from the performance over a given invoice period, the Company has elected to use the practical expedient for measuring progress toward the satisfaction of performance obligations and recognizes service revenue in the amount to which the Company has the right to invoice. Further, the Company has elected to apply the practical expedients to not disclose the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less and for (ii) contracts for which it recognizes revenue at the amount to which it has the right to invoice for services performed.

Types of Contracts
The Company provides services under four types of contractual arrangements with its payors:

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Negotiated Contracts - for these contracts, services are priced pursuant to a “plan of care” for the individual that encompasses habilitation and therapies. Such contracts are not subject to retroactive adjustment or cost reimbursement requirements. However, there may be instances where rates are adjusted based upon a change in circumstances with a particular individual or in situations where additional services are needed. Subsequent adjustments to rates, if any, are recognized when approved by the payor. For the three months ended December 31, 2018 and 2017 we recognized $136.2 million and $126.4 million, respectively, under these contracts.

Fixed Fee Contracts - for these contracts, payors set a standard rate or set of rates for a particular service usually dependent on the acuity of the individual being served. These rates are the same for all agencies providing the service. For these contract types, there is generally no cost report required. For the three months ended December 31, 2018 and 2017 we recognized $231.1 million and $217.5 million, respectively, under these contracts.

Retrospective Reimbursement Contracts - for these contracts, a provisional rate is set for the year pending the filing of an annual cost report that may further adjust that rate. Cost reimbursement rules differ by jurisdiction and program type. Revenue under these contracts is limited to the allowable costs under the contract. To the extent revenue exceeds the allowable costs it is deferred and reimbursed to the payor after the closeout of the contract. For the three months ended December 31, 2018 and 2017 we recognized $12.0 million and $26.6 million, respectively, under these contracts.

Prospective Payment Contracts - these contracts are cost reported in the same way as retrospective contracts, except the cost report for the annual period is used to set the rates in a future period. For these contracts, changes in rates are recognized in revenue prospectively. For the three months ended December 31, 2018 and 2017 we recognized $27.3 million and $24.9 million, respectively, under these contracts.

The Company has elected to apply the practical expedient and recognize incremental costs of obtaining a contract with amortization periods of one year or less as expense when incurred. These costs are infrequent and have historically been immaterial.
The transaction price under these contracts is based on gross charges for services, reduced by allowances for estimated sales adjustments and state provider taxes or gross receipts taxes levied on services the Company provides. Sales adjustments are estimated based on an analysis of historical sales adjustments and recent developments in payment trends. Subsequent changes to the estimate of the transaction price are recorded as adjustments to net revenue in the period of change.
In addition, all four contract types are subject to review by the third-party payors and may be subject to retroactive adjustment if in performing our services we have not adhered to the terms of the contract, or did not document our services as specified by the payor. Therefore, amounts due from third-party payors, primarily state and local government agencies and commercial health insurers, include variable consideration for retroactive revenue adjustments due to settlements of audits and reviews. We make estimates for these revenue adjustments based on our historical experience and success rates in the claim appeals and adjudication process. As of December 31, 2018 and 2017, liabilities to payors were $6.0 million and $8.2 million, respectively.
Revenue Mix
For the three months ended December 31, 2018 and 2017 the Company’s revenue by payor type was as follows:

20



For the three months ended December 31,
CSS
 
SRS
 
CFS
 
Corporate and Other
 
Consolidated
2018
 
 
 
 
 
 
 
 

State and local government
$
259,507

 
$
45,768

 
$
37,945

 
$
18,880

 
$
362,100

Non-public
83

 
38,859

 
78

 
7

 
39,027

Individual
942

 
4,476

 

 
86

 
5,504

Total
$
260,532

 
$
89,103

 
$
38,023

 
$
18,973

 
$
406,631

 
 
 
 
 
 
 
 
 
 
2017
 
 
 
 
 
 
 
 
 
State and local government
$
254,784

 
$
41,650

 
$
35,809

 
$
17,557

 
$
349,800

Non-public
128

 
39,680

 
66

 
23

 
39,897

Individual
979

 
4,659

 

 
83

 
5,721

Total
$
255,891

 
$
85,989

 
$
35,875

 
$
17,663

 
$
395,418

Revenue derived from contracts with state and local governmental payors in the state of Minnesota, the Company’s largest state operation, which is included in the CSS segment, accounted for approximately 15% of the Company’s net revenue for the three months ended December 31, 2018, and 16% of the Company’s net revenue for the three months ended December 31, 2017. Contracts with state and local governmental payors in California, the Company’s second largest state operation, which is included in the CSS and SRS segments, accounted for approximately 10% of net revenue for the three months ended December 31, 2018 and 2017. No other states accounted for 10% or more of our net revenue during the three months ended December 31, 2018 and 2017.

12. Net Income Per Share
The following table sets forth the computation of basic and diluted earnings per share (“EPS”):
 
Three Months Ended
December 31,
 (in thousands, except share and per share amounts)
2018
 
2017
Numerator
 
 
 
Net income
$
6,387

 
$
9,394

Denominator
 
 
 
Weighted average shares outstanding, basic (1)
36,162,345

 
37,472,018

Weighted average common equivalent shares
216,319

 
203,774

Weighted average shares outstanding, diluted (1)
36,378,664

 
37,675,792

Net income per share, basic and diluted
$
0.18

 
$
0.25

Equity instruments excluded from diluted net income per share calculation as the effect would have been anti-dilutive:
 
 
 
Stock options
947,683

 
519,872

Performance and restricted stock units
257,160

 
97,916

(1) The decrease in basic and diluted weighted average shares outstanding as compared to the three months ended December 31, 2017 is primarily due to the repurchase of 1,470,785 shares by the Company under the stock repurchase plan that was announced on February 8, 2018. The stock repurchase program expired on August 12, 2018, and the Company does not have authorization to repurchase any additional common stock under the program.

21




13. Commitments and Contingencies
    
The Company is in the health and human services business and, therefore, has been and continues to be subject to numerous claims alleging that the Company, its employees or its independently contracted host-home caregivers (“Mentors”) failed to provide proper care for an individual served by the Company. The Company is also subject to claims by these individuals, its employees, its Mentors or community members against the Company for negligence, intentional misconduct or violation of applicable laws. Included in the Company’s recent claims are claims alleging personal injury, assault, abuse, wrongful death and other charges. Regulatory agencies may initiate administrative proceedings alleging that the Company’s programs, employees or agents violate statutes and regulations and seek to impose monetary penalties on the Company. The Company could be required to incur significant costs to respond to regulatory investigations or defend against civil lawsuits and, if the Company does not prevail, the Company could be required to pay substantial amounts of money in damages, settlement amounts or penalties arising from these legal proceedings.

The Company is also subject to potential lawsuits under the False Claims Act and other federal and state whistleblower statutes designed to combat fraud and abuse in the health care industry. These lawsuits can involve significant monetary awards that may incentivize private plaintiffs to bring these suits. If the Company is found to have violated the False Claims Act, it could be excluded from participation in Medicaid and other federal healthcare programs which would have a material adverse effect on the business. The Patient Protection and Affordable Care Act provides a mandate for more vigorous and widespread enforcement activity to combat fraud and abuse in the health care industry.

The Company is also subject to employee-related claims under state and federal law, including claims for wage and hour violations under the Fair Labor Standards Act or state wage and hour laws, and claims for discrimination, wrongful discharge or retaliation. The Company currently has two pending complaints in California state court that allege certain
wage and hour violations of California labor laws and seek to be designated as class-actions. The Company’s policy is to accrue for all probable and estimable claims using information available at the time the financial statements are issued. Actual claims could settle in the future at materially different amounts due to the nature of litigation.

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion of our financial condition and results of operations should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended September 30, 2018, as well as our reports on Form 8-K and other publicly available information. This discussion may contain forward-looking statements about our markets, the demand for our services and our future results. We based these statements on assumptions that we consider reasonable. Actual results may differ materially from those suggested by our forward-looking statements for various reasons, including those discussed in the “Risk Factors” and “Forward-Looking Statements” sections of this report.
Overview
We are the leading national provider of home- and community-based health and human services to must-serve individuals with intellectual, developmental, physical or behavioral disabilities and other special needs. These populations are large, growing and increasingly being served in home- and community-based settings. Our clinicians and direct support professionals develop customized service plans, delivered in non-institutional settings, designed to address a broad range of often life-long conditions and to enable those we serve to thrive in less restrictive settings. We believe we offer a powerful value proposition to government and non-public payors, referral sources and individuals and families by providing innovative, high-quality and cost-effective services that enable greater independence, skill building and community involvement.
Since our founding in 1980, we have been a pioneer in the movement to provide home- and community-based services for people who would otherwise be institutionalized. During our more than 38-year history, we have evolved from a single residential program serving at-risk youth to a diversified national network providing an array of high-quality services and care in large, growing and highly-fragmented markets. While we have the capabilities to serve individuals with a wide variety of special needs and disabilities, we currently provide our services to individuals with intellectual and/or developmental disabilities (“I/DD”), individuals with catastrophic injuries and illnesses, particularly acquired brain injury (“ABI”) that we serve through our Post-Acute Specialty Rehabilitation Services (“SRS”), youth with emotional, behavioral and/or medically complex challenges, and elders in need of day health services to support their independence. As of December 31, 2018, we operated in 36 states, serving approximately 12,700 individuals in residential settings and approximately 18,700 individuals in non-residential settings. We have a diverse group of hundreds of public payors that fund our services with a combination of federal, state and local funding, as well as an increasing number of non-public payors for our services to individuals with acquired brain injuries or other catastrophic injuries and illnesses.
We operate our business in four operating divisions, Community Support Services ("CSS"), Specialty Rehabilitation Services ("SRS"), Children & Family Services ("CFS") and Adult Day Health ("ADH"). Each operating division represents a reportable segment except ADH which is included within Corporate and Other. As of October 1, 2018, Community Support Services and Children & Family Services are new names for the operating divisions formerly referred to as Intellectual and Developmental Disabilities (“I/DD”) and At-Risk Youth (“ARY”), respectively. There were no changes to the composition of the operating divisions as a result of these name changes. The segments have been organized by service line.
Our CSS segment is the largest portion of our business. Through the CSS segment, we provide home- and community-based human services to adults and children with intellectual and developmental disabilities. Our CSS programs include residential support, day habilitation, vocational services, case management, crisis intervention and hourly support care.
Through the SRS segment, which is our second largest segment, we deliver services to individuals who have suffered ABI, spinal injuries and other catastrophic injuries and illnesses. Our SRS services range from sub-acute healthcare for individuals with intensive medical needs to day treatment programs, and include, neurorehabilitation, neurobehavioral rehabilitation, specialized nursing, physical, occupational and speech therapies, supported living, outpatient treatment and pre-vocational services.
Through the CFS segment we provide home- and community-based human services to youth with emotional, behavioral and/or medically complex challenges. Our CFS programs include therapeutic foster care, family preservation, adoption services, early intervention, school-based services and juvenile offender programs.
Our newest operating segment, ADH, delivers elder services including case management, nursing oversight, medication management, nutrition, daily living assistance, transportation, and therapeutic services. The results of our ADH operating segment are included within Corporate and Other because ADH does not meet the thresholds for separate reporting.     

The Merger Agreement

22




On December 18, 2018, we entered into an Agreement and Plan of Merger (the “Merger Agreement”), by and among Celtic Intermediate Corp., a Delaware corporation (“Parent”), Celtic Tier II Corp., a Delaware corporation (“Merger Sub”), and Civitas Solutions, Inc. (“Civitas”), providing for the merger of Merger Sub with and into Civitas (the “Merger”), with Civitas surviving the Merger as a wholly owned subsidiary of Parent.

If the Merger is completed, each share of Civitas common stock issued and outstanding immediately prior to the effective time of the Merger (other than (i) shares of Civitas common stock owned by Civitas (excluding any shares of Civitas common stock owned by any subsidiary of Civitas, which will remain outstanding), Parent or Merger Sub and (ii) shares as to which appraisal rights have been properly demanded and perfected in accordance with Section 262 of the General Corporation Law of the State of Delaware) will be automatically cancelled and converted into the right to receive $17.75 in cash, without interest and subject to any applicable withholding taxes.

The consummation of the Merger is subject to certain customary conditions, including, but not limited to, (1) receipt of the vote in favor of the adoption of the Merger Agreement by a the holders of a majority of the outstanding shares of Civitas common stock entitled to vote on the Merger Agreement; (2) expiration of waiting periods (and any extensions thereof), if any, applicable to the consummation of the Merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, (3) the absence of a material adverse effect and (4) the absence of any law or order prohibiting, making illegal or enjoining the Merger.

The Merger Agreement contains certain termination rights, including the right of Civitas to terminate the Merger Agreement to accept a superior proposal, subject to specified conditions and limitations, and the right of either party to terminate the Merger Agreement if the Merger is not consummated by May 17, 2019. Upon termination of the Merger Agreement by Civitas or Parent upon specified conditions, Civitas will be required to pay Parent a termination fee of $20 million, and upon termination of the Merger Agreement by Civitas or Parent under other specified conditions, Parent will be required to pay Civitas a termination fee of $40 million.

For more information about the proposed Merger, see Note 2. Merger Agreement in the unaudited condensed consolidated financial statements included in this Quarterly Report.

Factors Affecting our Operating Results

Demand for Home and Community-Based Health and Human Services
Our growth in revenue has historically come from increases in the number of individuals served, as well as increases in the rates we receive for our services. This growth has depended largely upon acquisitions, development-driven activities, including the maintenance and expansion of existing contracts and the award of new contracts, and our new start program. We also attribute the long-term growth in our base of individuals served to certain trends that are increasing demand in our industry, including demographic, health-care and political developments.

Demographic trends have had a particular impact on our CSS business. Increases in the life expectancy of individuals with I/DD, we believe, have resulted in steady increases in the demand and length of stay for CSS services. In addition, family members currently caring for their relatives at home are aging and many may soon be unable to continue with these responsibilities. Many states continue to downsize or close large, publicly-run facilities for individuals with I/DD and refer those individuals to private providers of community-based services. Each of these factors affects the size of the I/DD population in need of services. Demand for our SRS services has also grown as emergency response and improved medical techniques have resulted in more people surviving a catastrophic injury. SRS services are increasingly sought out as a clinically-appropriate and less-expensive alternative to institutional care and as a “step-down” for individuals who no longer require care in acute settings.    
Political and economic trends can also affect our operations. Reductions or changes in Medicaid funding or changes in budgetary priorities by the federal, state and local governments that pay for our services could have a material adverse effect on our revenue and profitability. Recent efforts at the federal level to reduce the federal budget deficit, repeal and/or replace the Patient Protection and Affordable Care Act and/or restructure the Medicaid program pose risk for significant reductions in federal Medicaid matching funds to state governments. In addition, budgetary pressures facing state governments, especially within Medicaid programs, as well as other economic, industry and political factors could cause state governments to limit spending, which could significantly reduce our revenue, referrals, margins and profitability, and adversely affect our growth strategy. Government agencies generally condition their contracts with us upon a sufficient budgetary appropriation. If the government agency does not receive an appropriation sufficient to cover its obligations with us, it may terminate a contract or defer or reduce our reimbursements. In the past, certain states in which we operate, including Minnesota, California,

23



Massachusetts, Indiana, Arizona, and West Virginia, have implemented rate reductions, rate freezes and service reductions, in response to state budgetary deficits. While we are currently managing through a small number of rate decreases, we expect the overall rate environment to continue to remain stable in 2019.
Historically, our business has benefited from the trend toward privatization and the efforts of groups that advocate for the populations we serve. These groups lobby governments to fund residential services that use our small group home or host home models, rather than large, institutional models. Furthermore, we believe that successful lobbying by advocacy groups has preserved CSS and CFS services and, therefore, our revenue base for these services, from significant reductions as compared with certain other human services, although in the past certain states have imposed rate reductions, rate freezes, and service reductions in response to state budgetary pressures. In addition, a number of states have developed community-based waiver programs to support long-term services for survivors of a traumatic brain injury. However, approximately half of our specialty rehabilitation services revenue is derived from non-public payors, such as commercial insurers, managed care and other private payors.
Expansion of Services
We have grown our business through expansion of existing markets and programs, entry into new geographical markets, as well as through acquisitions.
Organic Growth
Various economic, fiscal, public policy and legal factors are contributing to an environment with a number of organic growth opportunities, particularly within the CSS and SRS segments, and, as a result, we have a continued emphasis on growing our business organically and making investments to support the effort. Our future growth will depend heavily on our ability to expand our current programs and identify and execute upon new opportunities. Our organic expansion activities consist of both new program starts in existing markets and expansion into new geographical markets. Our new programs in new and existing geographic markets typically require us to incur and fund operating losses for a period of approximately 18 to 24 months (we refer to these new programs as “new starts”). Net operating loss or income of a new start is defined as its revenue for the period less direct expenses but not including allocated overhead costs. The aggregation of all programs with net operating losses that are less than 18 months old comprise the new start operating loss and the aggregation of all programs with net operating income that are less than 18 months old comprise the new start operating income for such period. During the three months ended December 31, 2018 and 2017, new starts generated operating losses of $2.3 million and $1.2 million, respectively, and operating income of $0.7 million and $1.1 million, respectively.
Acquisitions
From the beginning of fiscal 2014 through December 31, 2018, we have completed 55 acquisitions, including several acquisitions of small providers, which we have integrated with our existing operations. Acquisitions could have a material impact on our consolidated financial statements.
During the three months ended December 31, 2018, we did not complete any acquisitions. During the three months ended December 31, 2017, we acquired the assets or equity interests of six companies for total consideration of $83.0 million, net of $0.8 million of cash acquired and including $1.1 million of contingent consideration.
Divestitures

We regularly review and consider the divestiture of under-performing or non-strategic programs to improve our operating results and better utilize our capital. We have made divestitures from time to time and expect that we may make additional divestitures in the future. Divestitures could have a material impact on our consolidated financial statements.

During fiscal 2018, we completed a comprehensive, top-to-bottom examination of each program’s performance across all of our operating divisions to improve the efficiency of our operations and mitigate margin erosion created by increasing labor and healthcare costs. As a result of this initiative, we decided to close and/or consolidate 58 programs during fiscal 2018 primarily within our SRS and CSS operating divisions (the “Program Closures”). These closures are expected to eliminate losses of $1.8 million annually. The comprehensive examination was completed during the fourth quarter of fiscal 2018 and there will be no additional closures associated with this review.
Revenue    


24



On October 1, 2018, the Company adopted Accounting Standards Codification Topic 606, Revenue from Contracts with Customers (ASC 606) applying the modified retrospective method. The adoption of ASC 606 did not have a material impact on the measurement nor on the recognition of revenue of contracts, for which all revenue had not been recognized, as of October 1, 2018, therefore no cumulative adjustment has been made to the opening balance of retained earnings at the beginning of 2018. See Note 11, Revenue Recognition.

Revenue is reported net of allowances for unauthorized sales and estimated sales adjustments, and net of any state provider taxes or gross receipts taxes levied on services we provide. We derive revenue from contracts with state, local and other government payors and non-public payors. During the three months ended December 31, 2018 and December 31, 2017, we derived 89% and 88% of our net revenue from contracts with state, local and other government payors, respectively, and 11% and 12% of our net revenue from non-public payors, respectively. Substantially all of our non-public revenue is generated by our SRS business through contracts with commercial insurers, workers’ compensation carriers and other private payors. The payment terms and rates of our contracts vary widely by jurisdiction and service type. We have four types of contractual arrangements with payors which include negotiated contracts, fixed fee contracts, retrospective reimbursement contracts and prospective payments contracts. Our revenue may be affected by adjustments to our billed rates as well as adjustments to previously billed amounts. Revenue in the future may be affected by changes in rates, rate-setting structures, methodologies or interpretations that may be proposed in states where we operate or by the federal government which provides matching funds. We cannot determine the impact of such changes or the effect of any possible governmental actions. In general, we take prices set by our payors and do not compete based on pricing.

We bill the majority of our residential services on a per person per-diem basis. We believe important performance measures of revenues in our residential service business include average daily residential census and average daily billing rates. We bill the majority of our non-residential service on a per service unit basis. These service units, which vary in length, are converted to billable units which are the hourly equivalent for the service provided. We believe important performance measures of revenues in our non-residential service business include billable units and average billable unit rates. We calculate the impact of these measures on gross revenue rather than net revenue because the timing of sales adjustments, both positive and negative, is unpredictable. We define these measures and gross revenue as follows:

Gross Revenue: Revenues before adjusting for sales adjustments and state provider and gross receipts taxes.
Average Residential Census: The average daily residential census over the respective period.
Average Daily Rate: A mathematical calculation derived by dividing the gross residential revenue by the residential census and the resulting quotient by the number of days during the respective period.
Non-Residential Billable Units: The hourly equivalent of non-residential services provided.
Average Billable Unit Rate: Gross non-residential revenue divided by the billable units provided during the period.



25



A comparative summary of gross revenues by service line and our key metrics is as follows (dollars in thousands, except for daily and billable unit rates):
 
Three Months Ended December 31,
2018
 
2017
Community Support Services
 
 
 
Gross Revenues
$
264,009

 
$
259,246

Average Residential Census
8,982

 
8,768

Average Daily Rate
$
250.60

 
$
247.31

Non-Residential Billable Units
2,985,398

 
3,135,751

Average Non-Residential Billable Unit Rate
$
19.07

 
$
19.05

Gross Revenue Growth %
1.8
 %
 
 
Gross Revenue growth due to:
 
 
 
Volume Growth
0.8
 %
 
 
Average Rate Growth
1.0
 %
 
 
Specialty Rehabilitation Services
 
 
 
Gross Revenues
$
91,250

 
$
87,638

Average Residential Census
1,423

 
1,414

Average Daily Rate
$
659.98

 
$
643.30

Non-residential Billable Units
62,222

 
50,721

Average Non-Residential Billable Unit Rate
$
78.02

 
$
78.20

Gross Revenue Growth %
4.1
 %
 
 
Gross Revenue growth due to:
 
 
 
Volume Growth
1.6
 %
 
 
Average Rate Growth
2.5
 %
 
 
Children & Family Services
 
 
 
Gross Revenues
$
38,494

 
$
36,267

Average Residential Census
2,297

 
2,119

Average Daily Rate
$
126.76

 
$
128.44

Non-residential Billable Units
137,209

 
135,387

Average Non-Residential Billable Unit Rate
$
85.28

 
$
82.96

Gross Revenue Growth %
6.1
 %
 
 
Gross Revenue growth due to:
 
 
 
Volume Growth
6.2
 %
 
 
Average Rate Growth
(0.1
)%
 
 
Adult Day Health
 
 
 
Gross Revenues
$
19,222

 
$
17,870

Non-residential Billable Units
1,071,550

 
991,081

Average Non-Residential Billable Unit Rate
$
17.94

 
$
18.03

Gross Revenue Growth %
7.6
 %
 
 
Gross Revenue growth due to:
 
 
 
Volume Growth
8.1
 %
 
 
Average Rate Growth
(0.5
)%
 
 
Consolidated Results
 
 
 
Gross Revenues
$
412,975

 
$
401,021

Gross Revenue Growth %
3.0
 %
 
 
Gross Revenue growth due to:
 
 
 
Volume Growth
1.8
 %
 
 
Average Rate Growth
1.2
 %
 
 


26




Expenses
Expenses directly related to providing services are classified as cost of revenue. These expenses consist of direct labor costs which principally include salaries and benefits for service provider employees and per diem payments to our Mentors; direct program costs such as food, medicine and professional and general liability and employment practices liability expenses; residential occupancy expenses which are primarily composed of rent and utilities related to facilities providing direct care; and other direct costs which include travel and transportation costs and other ancillary direct costs associated with the provision of services to individuals including workers’ compensation expense.
Wages and benefits to our employees and per diem payments to our Mentors constitute the most significant operating cost in each of our operations. Most of our direct support professionals are paid on an hourly basis, with hours of work generally tied to an individual’s need. Our Mentors are paid on a per diem basis, but only if the Mentor is currently caring for an individual. Our labor costs are generally influenced by levels of service, and these costs can vary in material respects across regions. In addition, our labor costs can be negatively impacted by higher rates of caregiver turnover, vacant positions and overtime utilization, as well as regulatory actions at the Federal, state, and local levels. For example, states and local governments set localized minimum wage increases, which in turn impact labor costs.
Occupancy costs represent a significant portion of our operating costs. As of December 31, 2018, we owned 352 facilities and 4 offices, and we leased 1,862 facilities and 197 offices. We expect occupancy costs of the continuing business to increase during fiscal 2019 as a result of new leases entered into pursuant to acquisitions and new starts. We incur no facility costs for services provided in the home of a Mentor.
Our business insurance programs include professional and general liability insurance, for which we are self-insured for $3.0 million per claim and $28.0 million in the aggregate, among others. We incurred professional and general liability expenses of $3.4 million and $3.3 million during the three months ended December 31, 2018 and 2017, respectively. These expenses are incurred in connection with our claims reserves and insurance premiums.
For our employment practices liability, we are fully self insured. We currently have two pending complaints in California state court that allege certain wage and hour violations of California labor laws and seek to be designated as class-actions. For the three months ended December 31, 2018 and 2017, we incurred employment practices liability expenses of $0.1 million and $0.9 million, respectively.
General and administrative expenses primarily include salaries and benefits for administrative employees, or employees that are not directly providing services, administrative occupancy costs as well as professional expenses such as accounting, consulting and legal services, and stock-based compensation expense.
Depreciation and amortization includes depreciation for fixed assets utilized in both facilities providing direct care and administrative offices, and amortization related to intangible assets.

27



Results of Operations

The following table sets forth our consolidated results of operations as a percentage of total gross revenues for the periods indicated.
 
Three Months Ended December 31,
2018
 
2017
Gross revenue
100.0
 %
 
100.0
 %
Sales adjustments
(1.5
)%
 
(1.4
)%
Net revenue
98.5
 %
 
98.6
 %
Cost of revenue
78.1
 %
 
78.9
 %
Operating expenses:
 
 
 
General and administrative
9.9
 %
 
11.1
 %
Depreciation and amortization
5.4
 %
 
5.4
 %
Total operating expense
15.3
 %
 
16.5
 %
Income from operations
5.1
 %
 
3.2
 %
Other income (expense):
 
 
 
Other income (expense), net
(0.3
)%
 
0.1
 %
Interest expense
(2.5
)%
 
(2.2
)%
Income before income taxes
2.3
 %
 
1.1
 %
Provision (benefit) for income taxes
0.7
 %
 
(1.3
)%
Net income
1.6
 %
 
2.4
 %
Three Months Ended December 31, 2018 and 2017
Consolidated Overview
 
Three Months Ended December 31,
 
Increase
(in thousands)
2018
 
2017
 
(Decrease)
Gross Revenue
$
412,975

 
$
401,021

 
$
11,954

Sales Adjustments
(6,344
)
 
(5,603
)
 
(741
)
        Net Revenue
$
406,631

 
$
395,418

 
$
11,213

Income from Operations
20,872

 
12,830

 
8,042

        Operating Margin (as a % of gross revenue)
5.1
%
 
3.2
%
 


Consolidated gross revenue for the three months ended December 31, 2018 increased by $12.0 million, or 3.0%, compared to the three months ended December 31, 2017. Gross revenue increased $7.7 million from acquisitions that closed during and after the first quarter of fiscal 2018 and $4.3 million from organic growth. Sales adjustments increased by $0.7 million, or 0.2% of gross revenue, compared to the three months ended December 31, 2017.

Consolidated income from operations was $20.9 million, or 5.1% of gross revenue, for the three months ended December 31, 2018 compared to $12.8 million, or 3.2% of gross revenue, for the three months ended December 31, 2017. The increase in our operating margin was primarily due to a decrease in direct labor costs and general and administrative expenses as a percentage of gross revenue. The decrease in direct labor costs was primarily attributable to changes in service line revenue mix and margin improvements resulting from the Program Closures that began during the second quarter of fiscal 2018. The decrease in general and administrative expenses as a percentage of revenue was primarily due to our efforts to manage costs and improve efficiencies and a decrease in expense associated with the Company’s deferred compensation plans. These plans have unfunded obligations that are linked directly to investment funds that were negatively affected by market performance during the three months ended December 31, 2018.

28



Community Support Services (CSS) Results of Operations
The following table sets forth the results of operations for the CSS segment for the periods indicated (in thousands):
 
Three Months Ended December 31,
 
 
 
 
 
2018
 
2017
 
 
 
 Change in %
of gross
revenue
 
Amount
 
% of gross
revenue
 
Amount
 
% of gross
revenue
 
Increase
(Decrease)
 
Revenue:
 
 
 
 
 
 
 
 
 
 
 
CSS gross revenue
$
264,009

 
100.0
 %
 
$
259,246

 
100.0
 %
 
$
4,763

 

Sales adjustments
(3,477
)
 
(1.3
)%
 
(3,355
)
 
(1.3
)%
 
(122
)
 
 %
CSS net revenue
260,532

 
98.7
 %
 
255,891

 
98.7
 %
 
4,641

 
 %
 
 
 
 
 
 
 
 
 
 
 
 
Cost of revenue:
 
 
 
 
 
 
 
 
 
 
 
Direct labor costs
171,219

 
64.9
 %
 
167,859

 
64.7
 %
 
3,360

 
0.2
 %
Direct program costs
10,696

 
4.1
 %
 
11,153

 
4.3
 %
 
(457
)
 
(0.2
)%
Direct occupancy costs
20,453

 
7.7
 %
 
18,707

 
7.2
 %
 
1,746

 
0.5
 %
Other direct costs
10,636

 
4.0
 %
 
12,094

 
4.7
 %
 
(1,458
)
 
(0.7
)%
Total cost of revenue
213,004

 
80.7
 %
 
209,813

 
80.9
 %
 
3,191

 
(0.2
)%
 
 
 
 
 
 
 
 
 
 
 
 
General and administrative
11,967

 
4.5
 %
 
13,102

 
5.1
 %
 
(1,135
)
 
(0.6
)%
CSS EBITDA
35,561

 
13.5
 %
 
32,976

 
12.7
 %
 
2,585

 
0.8
 %
 
 
 
 
 
 
 
 
 
 
 
 
Depreciation and amortization
10,599

 
4.0
 %
 
10,124

 
3.9
 %
 
475

 
0.1
 %
Income from Operations
$
24,962

 
9.5
 %
 
$
22,852

 
8.8
 %
 
$
2,110

 
0.7
 %
CSS gross revenue
CSS gross revenue for the three months ended December 31, 2018 increased by $4.8 million, or 1.8%, compared to the three months ended December 31, 2017. The increase in CSS gross revenue included $3.3 million from acquisitions that closed during and after the three months ended December 31, 2017 and $1.5 million from organic growth.
CSS EBITDA
    
CSS EBITDA was $35.6 million, or 13.5% of gross revenue, for the three months ended December 31, 2018 compared to $33.0 million, or 12.7% of gross revenue, for the three months ended December 31, 2017. The increase in our CSS EBITDA margin was primarily due to a decrease in cost of revenue and general and administrative expenses as a percentage of gross revenue compared to the three months ended December 31, 2017.
CSS cost of revenue for the three months ended December 31, 2018 decreased by 0.2% of gross revenue, compared to the three months ended December 31, 2017. This was primarily due to a 0.7% decrease in other direct costs partially offset by a 0.5% increase in direct occupancy costs as a percentage of gross revenue. The decrease in other direct costs was primarily due to a decrease in workers compensation expense attributable to favorable claims experience. The increase in direct occupancy costs was primarily due to increases in rent and utilities expense and higher vacancy rates within our intermediate care facilities.
CSS general and administrative expenses for the three months ended December 31, 2018 decreased by $1.1 million, or 0.6% of gross revenue, compared to the three months ended December 31, 2017. The decrease as a percentage of gross revenue was primarily due to our efforts to manage costs and improve efficiencies.
CSS Depreciation and amortization expense

Depreciation and amortization expense for the three months ended December 31, 2018 increased by $0.5 million, or 0.1% of gross revenue, compared to the three months ended December 31, 2017.

29



SRS Results of Operations
The following table sets forth the results of operations for the SRS segment for the periods indicated (in thousands):
 
Three Months Ended December 31,
 
 
 
 
 
2018
 
2017
 
 
 
 Change in %
of gross
revenue
 
Amount
 
% of gross
revenue
 
Amount
 
% of gross
revenue
 
Increase
(Decrease)
 
Revenue:
 
 
 
 
 
 
 
 
 
 
 
SRS gross revenue
$
91,250

 
100.0
 %
 
$
87,638

 
100.0
 %
 
$
3,612

 
 
Sales adjustments
(2,147
)
 
(2.4
)%
 
(1,649
)
 
(1.9
)%
 
(498
)
 
(0.5
)%
SRS net revenue
89,103

 
97.6
 %
 
85,989

 
98.1
 %
 
3,114

 
(0.5
)%
 
 
 
 
 
 
 
 
 
 
 
 
Cost of revenue:
 
 
 
 
 
 
 
 
 
 
 
Direct labor costs
46,687

 
51.2
 %
 
45,863

 
52.3
 %
 
824

 
(1.1
)%
Direct program costs
5,797

 
6.4
 %
 
5,824

 
6.6
 %
 
(27
)
 
(0.2
)%
Direct occupancy costs
10,613

 
11.6
 %
 
10,144

 
11.6
 %
 
469

 
 %
Other direct costs
2,604

 
2.8
 %
 
2,424

 
2.8
 %
 
180

 
 %
Total cost of revenue
65,701

 
72.0
 %
 
64,255

 
73.3
 %
 
1,446

 
(1.3
)%
 
 
 
 
 
 
 
 
 
 
 
 
General and administrative
7,403

 
8.1
 %
 
8,110

 
9.3
 %
 
(707
)
 
(1.2
)%
SRS EBITDA
15,999

 
17.5
 %
 
13,624

 
15.5
 %
 
2,375

 
2.0
 %
 
 
 
 
 
 
 
 
 
 
 
 
Depreciation and amortization
7,356

 
8.1
 %
 
6,753

 
7.7
 %
 
603

 
0.4
 %
Income from Operations
$
8,643

 
9.4
 %
 
$
6,871

 
7.8
 %
 
$
1,772

 
1.6
 %
SRS gross revenue
SRS gross revenue for the three months ended December 31, 2018 increased by $3.6 million, or 4.1%, compared to the three months ended December 31, 2017. The increase in SRS gross revenue included $2.0 million from acquisitions that closed during and after the three months ended December 31, 2017 and $1.6 million from organic growth.
SRS EBITDA

SRS EBITDA was $16.0 million, or 17.5% of gross revenue, for the three months ended December 31, 2018 compared to $13.6 million, or 15.5% of gross revenue, for the three months ended December 31, 2017. The increase in our SRS EBITDA margin of 2.0% was primarily due to decreases in cost of revenue and general and administrative expenses as a percentage of revenue, partially offset by an increase in net sales adjustments as a percentage of revenue compared to the three months ended December 31, 2017
Sales adjustments    for the three months ended December 31, 2018 increased by $0.5 million, or 0.5% of gross revenue, compared to the three months ended December 31, 2017.
Cost of revenue for the three months ended December 31, 2018 decreased by 1.3% of gross revenue compared to the three months ended December 31, 2017. The decrease was primarily due to a 1.1% decrease in direct labor costs resulting from lower contracted services expense and margin improvements associated with the Program Closures that began in the second quarter of last year.
General and administrative expenses decreased by $0.7 million, or 1.2% of gross revenue, during the three months ended December 31, 2018. The decrease as percentage of gross revenue was primarily due to our efforts to manage costs and improve efficiencies.
SRS Depreciation and amortization expense

30



Depreciation and amortization expense for the three months ended December 31, 2018 increased by $0.6 million, or 0.4% of gross revenue, compared to the three months ended December 31, 2017. The increase was primarily due to acquisitions during fiscal 2018 that have resulted in higher amounts of quarterly amortization for the acquired intangible assets.
Children & Family Services (CFS) Results of Operations
The following table sets forth the results of operations for the CFS segment for the periods indicated (in thousands):
 
Three Months Ended December 31,
 
 
 
 
 
2018
 
2017
 
 
 
 Change in %
of gross
revenue
 
Amount
 
% of gross
revenue
 
Amount
 
% of gross
revenue
 
Increase
(Decrease)
 
Revenue:
 
 
 
 
 
 
 
 
 
 
 
CFS gross revenue
$
38,494

 
100.0
 %
 
$
36,267

 
100.0
 %
 
$
2,227

 
 
Sales adjustments
(471
)
 
(1.2
)%
 
(392
)
 
(1.1
)%
 
(79
)
 
(0.1
)%
CFS net revenue
38,023

 
98.8
 %
 
35,875

 
98.9
 %
 
2,148

 
(0.1
)%
 
 
 
 
 
 
 
 
 
 
 
 
Cost of revenue
28,648

 
74.4
 %
 
28,090

 
77.5
 %
 
558

 
(3.1
)%
General and administrative
2,926

 
7.6
 %
 
2,973

 
8.2
 %
 
(47
)
 
(0.6
)%
CFS EBITDA
6,449

 
16.8
 %
 
4,812

 
13.2
 %
 
1,637

 
3.6
 %
 
 
 
 
 
 
 
 
 
 
 
 
Depreciation and amortization
1,391

 
3.6
 %
 
1,414

 
3.9
 %
 
(23
)
 
(0.3
)%
Income from Operations
$
5,058

 
13.2
 %
 
$
3,398

 
9.3
 %
 
$
1,660

 
3.9
 %
CFS gross revenue
CFS gross revenue for the three months ended December 31, 2018 increased by $2.2 million, or 6.1%, compared to the three months ended December 31, 2017. The $2.2 million increase in CFS gross revenue was due to a 6.2% increase in volume.
CFS EBITDA

CFS EBITDA was $6.4 million, or 16.8% of gross revenue, for the three months ended December 31, 2018 compared to $4.8 million, or 13.2% of gross revenue, for the three months ended December 31, 2017. The increase in our CFS EBITDA margin of 3.6% was primarily attributable to a decrease in cost of revenue that was driven by volume growth and changes in service line revenue mix compared to the three months ended December 31, 2017. In addition, general and administrative expenses decreased by 0.6% due to our efforts to manage costs and improve efficiencies.
CFS Depreciation and amortization expense
Depreciation and amortization expense for the three months ended December 31, 2018 remained flat compared to the three months ended December 31, 2017 at $1.4 million.

31



Corporate and Other Results of Operations
The following table sets forth the results of operations for Corporate and Other for the periods indicated (in thousands):
 
Three Months Ended December 31,
 
 
 
2018
 
2017
 
 
 
Amount
 
Amount
 
Increase
(Decrease)
Revenue:
 
 
 
 
 
Corporate and Other gross revenue
$
19,222

 
$
17,870

 
$
1,352

Sales adjustments
(249
)
 
(207
)
 
(42
)
Corporate and Other net revenue
18,973

 
17,663

 
1,310

 
 
 
 
 
 
Cost of revenue
14,999

 
14,100

 
899

General and administrative
18,736

 
20,348

 
(1,612
)
Depreciation and amortization
3,029

 
3,505

 
(476
)
Loss from Operations
$
(17,791
)
 
$
(20,290
)
 
$
2,499

Corporate and Other revenue

Corporate and Other revenue consists of revenue from our ADH business. ADH gross revenue for the three months ended December 31, 2018 increased by $1.4 million, or 7.6%, compared to the three months ended December 31, 2017. The increase in gross revenue included $2.4 million from acquisitions that closed during and after the three months ended December 31, 2017. Organic gross revenue decreased by $1.0 million primarily due to the Program Closures.
Corporate and Other cost of revenue
Corporate and Other cost of revenue consists of costs associated with our ADH business. Corporate and Other costs of revenue for the three months ended December 31, 2018 increased by $0.9 million, as compared to the three months ended December 31, 2017. As a percentage of gross revenue, Corporate and Other cost of revenue decreased by 0.9% compared to the three months ended December 31, 2017. This decrease as a percentage of gross revenue was primarily due to the closure and/or consolidation of lower margin programs.
Corporate and Other operating expense
General and administrative expenses for the three months ended December 31, 2018 decreased by $1.6 million as compared to three months ended December 31, 2017, primarily due to our efforts to manage costs and improve efficiencies and a decrease in expense associated with the Company’s deferred compensation plans..
Depreciation and amortization expense for the three months ended December 31, 2018 decreased by $0.5 million, compared to the three months ended December 31, 2017. The decrease in depreciation and amortization expense is primarily the result of certain intangible assets becoming fully amortized during fiscal 2018.
Consolidated Other income (expense)
Other income (expense), net, which primarily consists of interest income and changes in the net cash surrender value of Company owned life insurance policies, was an expense of $1.3 million for the three months ended December 31, 2018 compared to income of $0.4 million for the three months ended December 31, 2017.

32



Consolidated Interest expense
Interest expense for the three months ended December 31, 2018 increased by $1.2 million as compared to three months ended December 31, 2017. The increase is primarily the result of higher average debt balances due to the $75.0 million incremental term loan funded on October 25, 2017, the net proceeds of which were used for the acquisition of Mentis Neuro Rehabilitation, LLC in fiscal 2018.
Consolidated Provision (benefit) for income taxes
For the three months ended December 31, 2018, we had a provision for income taxes of $3.0 million, or a 31.8% effective tax rate, compared to a benefit of $5.1 million, or a (120.2)% effective tax rate, for the three months ended December 31, 2017. The benefit that resulted in the (120.2)% effective tax rate for the three months ended December 31, 2017 was due to revaluing of the Company’s deferred tax liabilities as a result of the enactment of the Tax Cuts and Jobs Act (the “Tax Act”) on December 22, 2017.
Liquidity and Capital Resources
Our principal uses of cash are to meet working capital requirements, fund debt obligations, and finance capital expenditures and acquisitions. Cash flows from operations and borrowings under our senior credit facility have historically been sufficient to meet these cash requirements. Our principal sources of funds are cash flows from operating activities, cash on hand, and available borrowings under our senior revolver.
Operating activities
Net cash provided by operating activities was $15.7 million for the three months ended December 31, 2018 and $8.8 million for the three months ended December 31, 2017. The increase in net cash provided by ope